An Index-Fund Evangelist Is Straying From His Gospel Common Sense By JAMES B. STEWART JUNE 22, 2017

An Index-Fund Evangelist Is Straying From His Gospel

Common Sense

By JAMES B. STEWART JUNE 22, 2017

In his classic 1973 book “A Random Walk Down Wall Street,” Burton Malkiel, a Princeton economics professor, made an assertion that was startling at the time: that “a blindfolded monkey throwing darts at the stock listings could select a portfolio that would do just as well as one selected by the experts.”

Three years later, Vanguard, the asset manager where Mr. Malkiel served on the board for 27 years, started the first passive index fund, an innovation that has swept the financial world.

Now, at age 84, Mr. Malkiel has had a remarkable change of heart: Maybe the experts can beat the monkeys after all. That is, if the experts are software engineers writing sophisticated algorithms for computer-generated trading.

Mr. Malkiel is chief investment adviser for Wealthfront, a pioneering automated investment manager that last week adopted a new approach it calls Advanced Indexing. The strategy aims to exploit market inefficiencies and beat the passive approach, based on an index weighted by stocks’ market capitalization, which Mr. Malkiel has long championed. This falls within a broad investing category known as “smart beta,” beta being a measure of the volatility of a security or a portfolio in comparison to the market as a whole.

“I have been a critic of smart-beta funds because they have typically been sold with high expense ratios and have ignored tax consequences,” Mr. Malkiel told me this week. “Smart beta has in effect been expensive beta.” But decades of academic research into efficient markets and Wealthfront’s ability to deliver a smart-beta approach at low cost, coupled with tax efficiency, finally won him over, he said.

Rob Arnott, founder of Research Affiliates, which devises smart-beta products for money managers like Pimco and BlackRock, greeted news of Mr. Malkiel’s conversion as “a fascinating turn of events.”

“Even though Burt Malkiel was never a die-hard efficient market person, he was pretty staunchly in that camp,” Mr. Arnott said. “He has acknowledged there may be some market inefficiencies, but any advantage from trading on them got eaten up in fees. Now the approach has become so cost-effective that even a skeptic like him is acknowledging it can add value.”

A large and growing body of academic research suggests there are market anomalies that can be exploited to beat a strict index approach. Some of that research has been recognized with Nobels in economic science — William F. Sharpe in 1990 and Eugene F. Fama in 2013. One of these findings is that value outperforms growth, rewarding those who identify stocks with lower price-earnings ratios and other metrics that suggest they’re undervalued. Another factor is momentum, in which stocks that are already outperforming market averages continue to do so.

Even so, “smart beta isn’t the kind of thing you hear talked about at cocktail parties, unless you move in very geeky social circles,” said Matt Hougan, chief executive of Inside ETFs, which provides research and conferences on exchange-traded funds.

That may change now that someone of Mr. Malkiel’s stature has thrown his weight behind it.

Wealthfront stressed that it was not abandoning the essence of Mr. Malkiel’s long-held belief in passive investing, and it calls its new approach PassivePlus. “Burt Malkiel is still the high priest of passive investing,” said Jakub Jurek, vice president for research at Wealthfront. “To be absolutely clear, we’re not stock pickers. There are decades of research on active investors, which show they underperform.” At the same time, he said, “there are small adjustments you can make to improve after-tax returns.”

In addition to value and momentum factors, Wealthfront’s approach embraces stocks with high dividend yields, low market beta and low volatility, all factors that “have proven robust across long time periods, geographies and asset classes,” Mr. Jurek said. (Wealthfront excluded another widely cited factor, small market capitalization, because its investment universe is limited to large-cap issues.)

Wealthfront’s testing against historical data indicates its multifactor approach outperformed a strict index approach by an average of 1 percentage point per year over the past 50 years, and even more since 2000, without any increase in volatility. As would be expected, there were some periods in which it underperformed.

“There’s a lot of statistical and, perhaps more important, behavioral support for these strategies,” Mr. Hougan said. “You’ll find plenty of two- or three-year stretches where this will underperform, but if you buy and hold, it’s going to add value. We’ve seen value outperform for over 80 years. And Wealthfront is blending five factors that should smooth out and reduce those periods of underperformance.”

Smart beta has its critics, including Mr. Arnott, viewed by many as the godfather of the field. “Smart beta can be smart, and then it can be not so smart,” Mr. Arnott said. “There are tons of strategies being offered now based on nothing but back tests. Anyone can create a brilliant strategy with benefit of hindsight. But does that mean anything for future returns?”

“Pretty much everyone is looking at the same factors, which is a danger,” he added. “It’s a very crowded space. If 10,000 quants are all looking at the same data and trading on it, the chances are that it’s not going to work.”

Mr. Jurek responded that “at a very general level, you could say that every back test is problematic.” But he stressed that “when designing Advanced Indexing, we relied on decades of peer-reviewed research to select factors that have stood the test of time” — even after being widely publicized — and “across asset classes.” He noted that smart-beta exchange-traded products account for about $500 billion in assets, still a relatively small fraction of total assets invested.

Multifactor smart-beta E.T.F.s are now available from many major fund providers, including BlackRock’s iShares, Invesco’s PowerShares, State Street’s SPDRs and WisdomTree E.T.F.s, but their track records are too short to draw any meaningful conclusions. And despite similar names and what purport to be similar strategies, their actual holdings can vary widely.

There are even more single-factor E.T.F.s, such as the venerable Vanguard U.S. Value Fund, started in 2000. Its 10-year annualized return as of this week was 5.8 percent, compared to 7.2 percent for the Standard & Poor’s 500-stock index.

Low-volatility funds, which tend to smooth out performance, have been especially popular since the financial crisis. The PowerShares S.&P. 500 Low Volatility Fund is the oldest, begun in 2011. It has a five-year annualized return of 13.6 percent, compared with the S.&P. 500’s 14.9 percent, according to Morningstar.

Mr. Malkiel stressed that low fees were critical in enhancing long-term smart-beta returns. Wealthfront charges its standard 0.25 percent management fee, with no additional charge for its Advanced Indexing feature. (Some smart-beta E.T.F. fees are even lower, although the average fee is over 1 percent.)

Mr. Hougan agreed. “You can easily waste away all the outperformance if the strategy isn’t carefully implemented,” he said. “We used to have to pay 1 percent and 1.5 percent to overpaid managers. Now we can get those strategies for 30 basis points or less. I think that’s great.”

A version of this article appears in print on June 23, 2017, on Page B1 of the New York edition with the headline: Monkey Throwing Darts Loses a Faithful Disciple