How to invest like the best: tracker-fund champion Burton Malkiel

Burton Malkiel, the ‘father of passive management’. Credit: AFR picture by JESSICA SHAPIRO/Fairfax Media via Getty Images.

Burton Malkiel may be less well-known than household-name investment gurus such as Warren Buffett and Peter Lynch, but he has been just as influential.

The American economist’s work is a major threat to the golden goose: Malkiel’s theories very much undermine the business model of large parts of the asset management industry. Think of him as the father of passive management.

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Born in Boston in 1932, Malkiel earned economics degrees from both Harvard and Princeton universities; he spent a brief period in investment banking in the late 1950s before joining the faculty at Princeton and building his career in academia. Although he published widely throughout the 1960s, Malkiel really came to public prominence in 1973 with his book A Random Walk Down Wall Street.

Described by reviewers as “one of the few great books about investment” ever written, it might also be one of the most dangerous. Malkiel’s central theory is that share prices move completely unpredictably – they take a “random walk” – making it impossible to second-guess future movements by looking at past trends. The implication is that it’s futile for investors – amateur or professional – to think they can earn superior returns through stock picking and market timing.

It’s not difficult to see why A Random Walk Down Wall Street caused such a stir. “On Wall Street, the term ‘random walk’ is an obscenity,” Malkiel wrote. “It means a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by the experts. Financial analysts in pin-striped suits do not like being compared with bare-assed apes.”

Don’t let the laconic writing style fool you. Malkiel’s work is refreshingly accessible, but it’s also based on robust research that builds on the efficient market hypothesis first set out by Eugene Fama, who won a Nobel Prize for Economics.

As the name suggests, the hypothesis asserts that stock markets are efficient – that share prices reflect all the available information at any given time.

If that’s the case, the two routes typically used to assess the value of a stock and, therefore, its prospects, are both pointless. Fundamental analysis, which looks at a company’s current financial condition – its earnings, assets, borrowings and growth, for example – won’t uncover any useful information because all those variables are already reflected in the price.

Equally, technical analysis, which looks at the historical price movements of the stock in an attempt to discern patterns that can be projected forward, is no use either, since that information must also be in the price already.

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In this world, past prices and other data provide you with no clues about future price movements. Price changes will only occur as a result of new information emerging – and even this will be absorbed by the market almost immediately. Efficient markets move rationally, but that’s no help to investors who can’t know in advance what new information will come out. From where we stand today, individual stock prices will take a random walk.

These are radical challenges to the basics of investment that we’re often taught to cling to – that through extensive research and careful assessment, we can work out which stocks will outperform. The problem, efficient marketeers point out, is that so many people are doing such research and assessment that the market has already assigned the right value to every company. Only with inefficiency would it be possible to get an edge on other market participants.

Think honestly about your experience of investment and Malkiel’s theories start to feel less radical. Every financial services organisation is mandated by regulators to remind you loudly and often that past performance is no guide to the future. That is the reality – hot shares don’t remain hot forever; star fund managers almost always disappoint in the end.

Indeed, the evidence is that most active fund managers struggle to escape Malkiel’s orbit. In research published last year, Morningstar found that just 14% of active managers had, over the previous 10 years, outperformed funds that simply tracked the market rather than trying to beat it. Almost all those active funds, naturally, will have charged significantly more than their passive peers.

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This is not to say Malkiel’s theories are universally accepted. Critics argue that A Random Walk Down Wall Street paints too simplistic a picture – some markets, or segments of markets, are less efficient, they argue, making it possible for smart investors to exploit poorly understood information. They also point out that market bubbles and stock market crashes don’t make sense in Malkiel’s world, since they are sudden shocks for which efficient market theory should leave no room.

Still, Malkiel’s work has stood the test of time. The experience of investors has been, all too often, that stock picking and market timing are pursuits that disappoint – certainly over short-term periods.

As for Malkiel himself, his earnings from academia were increasingly supplemented by consultancy work and part-time roles at investment businesses. He spent 28 years as a director of the large US fund manager Vanguard, known for pioneering the widespread use of passively managed funds, before retiring in 2005.

Not that he completely abhors the idea of trying to beat the market. Malkiel’s hobbies include gambling – both at the casino and on horse racing – where he has applied mathematical and statistical analysis to try to beat the house. Just don’t confuse this sort of speculation with investment – a distinction Malkiel is at pains to make himself.

How to invest like Burton Malkiel

At first sight, investing in line with Malkiel’s principles would mean not trying to pick individual shares or active funds you think will beat the market. Indeed, Malkiel is a longstanding supporter of passive investment approaches. “Indexing is a serviceable and feasible strategy for individual investors,” he advised in A Random Walk Down Wall Street. “It is the strategy I most highly recommend for individuals and institutions.”

In which case, your goal should be to find the most affordable and practical passive funds for tracking individual markets and asset classes. There are a huge number of passive options in both developed and developing markets, enabling you to construct a diversified portfolio that reflects Malkiel’s arguments. Our guide to the cheapest ways to access global markets, including the UK, US and emerging markets, is a good resource to use as part of wider research.

That said, Malkiel isn’t entirely against active investment, for those prepared to put some effort into finding the best opportunities. A Random Walk Down Wall Street included four principles for identifying stocks you can buy and hold for long-term growth, rather than getting hung up on short-term potential. Look for companies that appear able to sustain above-average earnings growth for at least five years, he suggested. Never pay more for a stock than can reasonably be justified by a firm foundation of value. Buy stocks with stories that other investors are likely to buy into. And trade as infrequently as possible.

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“Effectively, Malkiel is advocating going down the Warren Buffett route of buying high-quality long-term growth businesses such as Coca-Cola Co (NYSE:KO) and American Express Co (NYSE:AXP),” observes Ben Yearsley, a director of Fairview Investing. “Hold them through thick and thin and ignore the dips.”

Richard Hunter, head of markets at interactive investor, makes a similar point. “Look at companies with a strong track record of profitable growth, an economic moat, exposure to growing regions or even all of these,” he argues. “In addition, a strong balance sheet and spare cash for investment is a bonus, while investor can also benefit from the power of compound interest over time by reinvesting dividends.”

Two UK companies that could fit the bill are Tesco (LSE:TSCO) and Prudential (LSE:PRU), Hunter adds.

Equally, if you do want active funds to complement your passive approach, look for a manager who invests this way. “You could argue that Baillie Gifford is the purest proponent of this philosophy,” adds Yearsley. “Scottish Mortgage Ord (LSE:SMT) is the embodiment of the Baillie Gifford philosophy and approach and is the manager’s best product.”