"China has been the world's growth story," exclaims noted Princeton University economist Burton Malkiel. "Its rate of expansion over the last 20 years has been unprecedented. No country in modern times has grown at anything like this-not South Korea, not Japan, not the U.S."
For Malkiel, China has been a game-changer. It has not only focused his attention on the other side of the globe, where it is kick-starting markets that do business with it, but China has also prompted this most committed passive investor to reconsider how he sees the world.
Author of the venerable tome A Random Walk Down Wall Street, and co-author of From Wall Street to the Great Wall and The Elements of Investing, Malkiel has long been critical of active portfolio managers and analysts, proclaiming that a blindfolded chimpanzee throwing darts at The Wall Street Journal could select a portfolio that would do as well as the experts.
This led him early on to profess the superiority of low-cost broad market index funds over active management. But China and the gathering strength of emerging markets have challenged Malkiel's belief that market-cap weighting alone is the best way to skin a market.
Something Different
In fact, he is making a decisive turn toward a more active strategy himself in the model portfolio he suggests for a 40-something family bread earner. Sanguine about the future, he's recommending 80% exposure to stocks, with half of that in foreign companies. That's not too far off the non-U.S. global weighting of 56.14% in the MSCI All Country World Index. But Malkiel does goes off the path of simple market-cap weightings with his 25% exposure to both the MSCI EAFE index (which includes the developed world, without the U.S. and Canada) and to emerging markets. MSCI EAFE represents 41% of the global market cap. MSCI emerging markets make up less than 13%.
To Malkiel, this major adjustment is simply his acknowledgement of the new economic order. He doesn't believe Europe and Japan-the key components of EAFE-will see significant growth in the coming years. He believes emerging markets will be driving global economic expansion, and that long-term investors will be best served by a significant exposure to places like Brazil, India and China.
While he continues to teach at Princeton, Malkiel also works as the chief investment officer of the Chinese fund advisory AlphaShares. This company has crafted a series of indices that capture specific Chinese sectors such as infrastructure, consumer products and technology, as well as broader swatches of the market. ETFs now track several of these indices: a real estate index (whose ETF ticker is TAO), an all-cap index (YAO) and a small-cap index (HAO).
The firm also has developed a unique set of private, actively managed funds as well. To access China from the ostensibly safer shores of more established markets, Malkiel created a China-linked fund that invests in non-Chinese firms benefiting from the mainland's growth. Another portfolio, the Enhanced Index (Red Dragon) Fund, bets that broad-market returns can be improved by overweighting small-cap and value stocks. And the firm's AlphaShares' Buy-Write (Green Dragon) Fund tries to exploit Chinese equity volatility by investing in the highly liquid FTSE Xinhua 25 Index and writing options against it to pick up premium income.
So with so many active, discretionary plays, is Malkiel changing his stripes? If not, his stripes certainly don't appear in the same pattern they used to. His funds are making an argument that shrewd market observers can indeed outperform traditional indices, especially when markets aren't completely transparent or efficient.
By shifting from developed to emerging markets, he explains, "my portfolio strategy remains passive; I'm not picking stocks. But I am adjusting for economic realities which go beyond market capitalization."