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Why the father of indexing invests in stocks and funds

Don't think of those ETFs in your portfolio as index funds. Think of them as little pieces of Burton Malkiel.

The author of A Random Walk Down Wall Street has been pounding the indexing drum ever since his investing classic first appeared in 1973. A proponent of the efficient market hypothesis, which holds that stock prices reflect all relevant information, the 78-year-old Princeton economics professor believes it's largely pointless to try to beat the market.

Instead, most investors are better off trying to be the market by buying broadly-based, low-cost index funds that passively track major benchmarks.

But as he tells John Heinzl, even the world's most famous index investor can't resist investing some of his money in actively-managed mutual funds and individual stocks.

How has investing evolved since the first edition of A Random Walk appeared?

The biggest change has been that Wall Street has caught up with the message. There weren't any index funds at that time. Now there are a variety of index funds and the fastest-growing part of the market are exchange-traded funds, and they have lower and lower expenses as we go along.

We've seen growth in the ETF marketplace. Is the choice helping or hurting index investors?

I don't think that every ETF is great - buying something that gives you three times the change in the S&P 500, for example. I think a lot of this is crazy. I think a lot of the really narrow ETFs are crazy. The good thing is that you can now get an expense ratio that's close to zero on very broad-based index ETFs.

Why is it so important to have very broad index funds?

In the 1970s, the U.S. was the economic power. It had most of the world's economic activity, it had the lion's share of the world stock markets. Today, the U.S. has maybe 20 per cent of the world's economic activity and the U.S. stock market is maybe 40 per cent of the capitalization of the world's stock market. So there is just much more scope for international diversification and in my view the emerging markets, which now as a group are about 45 per cent of the world economy, deserve a much larger share in most people's portfolios than they have.

Do you recommend that investors religiously stick to an indexing strategy, or is there room for individual stocks or sectors?

What I have always said is that you if you index the core [of the portfolio] you can do a little active [management] around the edges. I've often said that telling an investor you can't beat the market is like telling a six-year-old that Santa Claus doesn't exist. I don't index everything. I have some actively managed funds, I buy some individual stocks, but I can do that with much less risk because the major part of my retirement funds are in broad-based index funds.

I'm surprised to hear that you invest in actively managed funds, because one of your messages is that no fund manager can consistently beat the market.

That's absolutely right. What I have done is I have been a long-term director of the Vanguard Group and in getting to know one or two active managers I thought they were particularly adept at a specific area and that maybe they won't outperform over the long haul but I thought it was worth a chance. One of them is a California manager who I think is particularly adept at understanding the technology industry and another is a Boston manager who I think has a particular understanding of the health care industry. I've also invested in a couple of closed-end funds when they have been available at big discounts.

And individual stocks?

I want some exposure in my portfolio to commodities because I expect China to continue to grow at rapid rates. So one of my favourites that I still own and have done very well with is copper and gold producer Freeport McMoran. In terms of a Canadian company, again for the same kind of reasons, I own Potash.

We're hearing a lot of forecasts for 2011. How much attention do you pay to them?

Short-run forecasts for the market are really next to useless.

If markets are efficient, how do you account for the performance of star investors like Warren Buffett and Peter Lynch?

Peter Lynch had a very short outperformance and he quit while he was ahead. My sense of Warren Buffett is he is not someone who buys when it's cheap and sells when it's expensive. What he's done is bought companies instead of individual stocks and he's had an active role in making those companies click. One of the first great investments was the Washington Post. Well, he went on the board and he helped turn around the Washington Post. And similarly, with Geico and everything he's done. Look, he's a brilliant businessman, there's no question about it. Having said that, though, I don't think his record is so great simply because he read Graham and Dodd and bought value stocks when they were cheap.

Even index investors would have been burned by the technology bubble, and more recently by the subprime meltdown. Didn't active investors see these things coming and get out in time?

Yes, I agree that bubbles exist, but it's impossible to determine when you're in the middle of one. Only after the fact do we all have 20-20 vision that the past mispricing was obvious.

There is lot of anxiety about the shaky U.S. economy, high unemployment and problems in Europe. What message do you want to send to investors?

Don't try to time the market. If you always say, "Oh my god there is so much uncertainty, there are so many things that can happen," you will make the classic mistake that investors make: They put their money in when everything seems to be optimistic, they take their money out when there seems to be all kinds of problems. That invariably is the wrong thing to do.

© 2007 The Globe and Mail. All rights reserved.

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