Walk it Back, Random Walker

Big news, nerds – Burton Malkiel has changed his mind.  The investment legend, who has spent his entire life chastising alpha chasing active management, has moved over to the dark side. Malkiel, the Chief Investment Officer at Wealthfront has rolled out a new strategy that they’re calling “Passive Plus” indexing. The strategy is another name for Smart Beta which is another name for active deviations from market cap weighting.  This is a big change in views considering he said this just a few years ago (link was deleted by WealthFront for obvious reasons):

“‘Smart Beta’ portfolios are more a testament to smart marketing rather than smart investing.”

Then again, this big change doesn’t remotely surprise me. I’ve been kind of a meanie to Malkiel over the years (see here, here, here or here).¹ My basic view is and has been:

• The Efficient Market Hypothesis is a useless theory that basically says “prices move and markets are hard to beat after taxes and fees”.
• Our entire industry misuses the terms “active” and “passive” in ways that mostly just cloak the way high fees are charged in certain products.
• These confusions are directly connected and are due to inconsistent underlying theories about the way the financial markets work. More importantly, the terms are consistently misused to sell high fee products and especially products that are higher fee than market cap weighted products.

So, what’s happening with Malkiel? Why is he suddenly embracing the alpha chase via Smart Beta? In my view he’s changed his mind because he never really had a cohesive and consistent underlying theory in the first place. Malkiel was always an advocate of active investing whether he understood it or not. This was evident long ago when he wrote articles about picking the best dividend paying stocks (which turned out to be the worst) or when he said no one should hold one of the largest asset classes in the world (he was making a purely political argument that was anything but random walking).  Malkiel never walked the random walk.

This is important because it means that some of the foundational theories that investors rely on are incorrect. It means that the academic work that these theories are built on is also wrong. But what’s happening now is more troubling in my opinion. What he’s done is pivoted from one form of active management to another worse form (market cap weighted to factor picking). Smart Beta and Factor Investing are nice sounding theories backed by lots of academic research. But they are also largely untested in the real-world and generally involve higher taxes and fees. They are, to be blunt, strategies that sell the hope of alpha in exchange for the guarantee of higher fees.²

I know, I know. I am super dumb for criticizing the geniuses of our industry who have constructed these ideas. If I were smart I’d build some sort of Countercyclical Indexing ETF that embedded factors and all the mountains of academic research that support it. That would be pretty clever of me. But a big part of me wonders if we’re not seeing a huge transition in the asset management business where investors shift from active stock picking to asset and factor picking. And asset managers are embracing this trend because it’s a more palatable way to implement active management, look more like index funds and still charge higher relative fees.  Personally, I suspect this is more flawed thinking based on unsound academic theorizing. I have no idea if I am right. But as a default rule, when someone tries to sell you alpha in exchange for management fees you should be extremely skeptical….I know I certainly am.

¹ – I don’t mean to pick on Malkiel personally. It’s just that his IDEAS rely on so many terribly twisted concepts that some clarity here is helpful.  I also don’t mean to pick on WealthFront, which, relative to most other asset managers is a pretty harmless low fee service. Although I must say that I haven’t changed my mind on the view that most robo advisor services are silly and little more than a target date mutual fund wrapped in a more complex looking service.  

² – Some firms will promise that these kinds of strategies can be implemented in more tax and fee efficient manners, but this is largely untested and certainly unproven in the real-world over any relevant time horizon.  

NB – Some people might ask, “who cares about all this theory?” I guess the point is that I like to know how things work and right now I feel like the investing operating manual is basically wrong. It’s like we’re driving a car around town trying to do all the wrong things. The car works okay, but it’s not optimal for most people and those who make the car are structuring it incorrectly so it doesn’t meet the goals of the drivers. Getting the operations and the owners manual right seems pretty important to me.