Burton Malkiel's Index of Insights

The Random Walk guru offers his take on ETFs, annuities, and how investors should react to rising interest rates

Exchange-traded funds have proliferated over the past six years as investors have become more conscious of the need for diversified portfolios to protect themselves from exposure to specific stocks. According to a new report by Morgan Stanley (MS), 116 ETFs were issued in the first four months of this year, three-quarters of the number issued for all of 2006. ETFs achieve much of the same investment aims as mutual funds without the costly transaction fees.

The passive buy-and-hold technique common to index funds has proved over time to outperform the returns investors realize through actively managed mutual funds or individual stock picks, says Burton Malkiel, who has just come out with an updated, ninth edition of his book A Random Walk Down Wall Street. When it comes to ETFs, he prefers that they be broad-based, and he emphasizes that he likes ETFs because they are index funds.

He also made it clear that his advocacy of an index-fund strategy doesn't preclude setting up what he calls a "satellite portfolio" of actively managed funds or even individual stocks that enable investors to take bets on enhanced returns. This provides a way for investors to focus on a particular industry they think has better-than-average growth potential or to use the specific expertise of an active-fund manager.

Most important is that a satellite portfolio should have low to zero correlation with what's in your primary indexed holdings, as it reduces the risk of the whole portfolio.

BusinessWeek's David Bogoslaw met with Malkiel on the sidelines of a Barclays Global Investors seminar about ETFs June 12 in New York. Edited excerpts of their conversation follow:

Your view on ETFs is generally positive?

My take on ETFs is that if you have a certain amount of money and you're putting a lump sum into the stock or bond market, an ETF is a sensible way to do it. It's cheaper than a mutual fund because a mutual fund has to have a transfer agent to take care of all the people involved in a transaction [which makes for higher fees].

If you own an IRA and are in the habit of putting $200 a month into your IRA, it's better to go with a mutual fund because of the brokerage costs you pay every time to get into an ETF.

The one thing about which I am absolutely certain is that if I pay less in fees, there is going to be more for me.

What have you made current in the new edition of A Random Walk Down Wall Street?

While the basic message hasn't changed in that it says indexing is a smart way to approach investing, what's changed is the kind and number of instruments available to people. When I first wrote this book in 1973, there were no money-market funds, no municipal bonds, no 529 college savings plans.

As new instruments have become available and there are new opportunities for people to save on taxes, the book continues to ask: Was the [original] advice on index funds right? Are you better off by investing in them?

There are not a lot of ideas that have come out of the academy that work, and [indexing] is one that works!

Whatever new [investment instruments] that have come out, there are two big things that I've added to the ninth edition of the book: (1) a new chapter on behavioral finance [that highlights] lessons for the investor that are good and the lessons for people to be cautious about, and (2) a new chapter on investing for retirement, given there are a lot of baby boomers who will be retiring soon.