(Bloomberg) — When Burton Malkiel published A Random Walk Down Wall Street 50 years ago, he said a blindfolded chimpanzee throwing darts could pick a stock portfolio that would do as well as one created by experts.
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The professor of economics at Princeton University argued that the smarter strategy would be to own a portfolio of all the stocks in a broad-based index — a product that didn’t exist then. Today, some $5.7 trillion sits in index funds.
The 90-year-old, who is also chief investment officer at roboadviser Wealthfront, hasn’t wavered in his faith in passive investing even after a year when market volatility allowed more active fund managers to beat their benchmarks.
The excerpts below from a phone conversation with Malkiel have been lightly edited for clarity.
Q. Has your view of the wisdom of index-fund investing changed over the years?
A. My view is that the case for passive is stronger than ever. More than half of fund assets are in index funds, and the reason for the success is that the evidence just gets stronger and stronger that index investing is not mediocre investing, it is above-average investing.
I’ve done empirical work over the course of 50 years, and SPIVA [the S&P Indices Versus Active scorecard] has done work showing that over the past 20 years about two-thirds of active managers are beaten by the index, and the rough third of active managers that win in one year aren’t the same ones that win in the next year. Compound that over 10 years, SPIVA finds that 90% of US active funds underperform their benchmark index.
Q. Data show an increase in the percentage of active funds outperforming their index in 2022. Companies with actively managed funds like to say that a sideways or declining market is a time when active managers can shine. What’s your take?
A. When markets are bad and declining, it is the case that active does not do as poorly as it usually does. SPIVA’s report for the first half of 2022 found that 51% of active managers underperformed the S&P 500. But that’s six months, so you shouldn’t put too much stock in that. My work has suggested that it actually is the case that in bear markets the [performance] gap between active and passive fund management is smaller. But is it the case that where active management really works is in tough markets? My answer is absolutely not.
The reason is very simple. All mutual funds keep a cash reserve because they have to meet client redemptions. The index fund keeps a cash reserve too, but because it has to track an index it offsets the cash reserve with futures contracts so that it is 100% invested at all times. When the market does down, 100% of the assets in the index fund go down and maybe 95% or so of the assets in active funds go down, so they get the advantage of the cash reserve that the index fund doesn’t have.
Q. We’ve seen the market-capitalization-weighted S&P 500 become a momentum index in bull markets. Are there growth and value tilts like that that individual investors should keep in mind when they buy a particular index fund?
A. My view is that you don’t buy an S&P 500 Index fund. You really want something broader, a total stock market fund. Criticism of the S&P 500 for concentration in some huge mega-cap stocks — some of that is fair, and I do want some small-cap funds in a portfolio, which is one of the other reasons I prefer a total stock market fund. You offset the concentration of an index like the S&P 500 in mega-cap stocks to some degree by buying a total stock market fund. Even with a total stock market fund you may have too much in stocks like Apple or Microsoft, but you don’t avoid that by going with active funds because if you look at the active funds they have exactly those same stocks.
Q. Are there areas in the market where active management does tend to do better than passive?
A. You’d think in the least-efficient markets, like the emerging markets, that we ought to be able to find some active outperformance. But interestingly enough, if anything active does worse than passive in emerging markets, where presumably good research ought to be able to have an advantage.
If you ask me if there is any place in the whole investment universe where active does make sense, I’d point to endowments, where you get a risk premium for accepting illiquidity. Active might have a benefit in the private real estate markets, maybe in some of the private lending markets.
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