Nobel laureate Eugene Fama gave a rare interview yesterday, and it’s well worth watching.
Professor Fama is best known for his empirical work on portfolio theory, asset pricing and the efficient market hypothesis.
He was interviewed at the Booth School of Business at the University of Chicago by financial adviser, blogger and friend of TEBI, Barry Ritholtz. The interview is part of Bloomberg’s Masters in Business series.
Here are 14 things we learned.
The efficient markets hypothesis was born out of computers
“Before 1960, you really didn’t have a serious computer to do data analysis on and, with the coming of computers, statisticians and economists had a new toy to play with and stock prices were easily available. So (fund performance) was one of the first things they started to study. And then immediately the economists said, how do we expect prices to behave, if the world was working properly? In other words, if markets were efficient. They weren’t using that term but that’s what they were after, and there were all kinds of theories proposed that had lots of shortcomings to them, and a little at a time we came to the efficient market hypothesis.”
We shouldn’t be surprised that passive trumps active
“Back then, there was no real evidence on how (fund managers) did. And one of the first papers was Mike Jensen’s thesis here, which studied mutual funds for the previous 25 years and showed, basically, they weren’t beating the market. Now we know, in hindsight, that in fact that has to be true — that active management is a zero-sum game before costs — because they can’t win from the passive managers because the passive people hold cap-weight portfolios. They don’t overweight and underweight in response to what the active people do. So if there’s anybody underweighting and overweighting, there has to be another active manager on the other side doing the opposite. Which means, if one wins, the other loses. The sum of those is zero, before costs. In William Sharpe’s The Arithmetic of Active Management, he calls it arithmetic because it is arithmetic. It’s not a proposition, it has to be true!”
Markets were efficient before the advent of technology
“It should make it better. But the truth is, prices are so volatile that markets have always looked really efficient. They don’t look any more efficient than they ever have with the introduction of all the new technology. Information is spread much more quickly now than it was 50 years ago because you have so many sources, and they’re so quick. But you can’t really see in the data that that’s had a quantum effect on the adjustment of prices to information.”
It was Fama who introduced David Booth to his DFA co-founder
“Mac McQuown, who was (at) Wells Fargo, came to all the seminars we did here for business people. We did them twice a year. The Center for Research in Securities Prices ran seminars for interested business people and Mac came to all of them, and he seemed very into the new stuff. So, when David said (to me), “I see what you do, but I don’t want to do it” I called Mac and said I have a really good student here if you’ve got a place for him, and he did.”
We can’t read anything into the fact that growth is still beating value
“Well, the question (people) want to ask is, is value dead? Ken (French) and I are actually writing a paper on this at the moment, but the bottom line is, there’s so much volatility in these premiums that you can’t tell if the premium has changed or not. It may have changed, it may not. You just can’t tell. You’re well within the range of chance — the poor returns experience is well within the range of chance — over the time that it’s occurred. So you really can’t say anything.
“I don’t think there are real cycles to it. I think it’s just kind of random that you go through good and bad periods, and you can’t recognise them except after the fact. You can’t really predict them, and we’ve tried predictive tests and they have marginal value. Nothing worth even focusing on. So basically, you’re stuck with volatility of equity returns. They don’t allow you to say very much about what’s happening to expected returns going forward.”
Much of the research into factors is down to the pressure to publish
“Lots of these things are just manifestations of the same thing. So value can be measured in many different ways: you can use the book-to-market ratio and you can use cash flow to price. I can use lots of different variables to identify what is basically the same thing. And there are thousands of finance professors out there, who all want to get tenure. They have to publish to do that, so they’re all just kind of searching through the data, finding stuff that may be there only on a chance basis — that won’t be there on a sample. So there’s lots of work being done and that remains to be done on what we call robustness.”
He and Richard Thaler agree to disagree on behavioural finance
“My good friend Richard Thaler… is the king of the behavioural finance people. I tease him and say that I’m the most important person in behavioural finance. Because most of behavioural finance is just a criticism of efficient markets, so without me, what have they got?!
“The reality is that we agree on the facts, we disagree on the interpretation. For example, he thinks that the value premium is a result of people’s misperceptions of what accounting information and other information looks like. It’s all based on misinterpretation of information. Now, if you believe that, then you’d think it should go away, because it’s possible to teach people that they have these biases. Professional managers should be able to get past them.
“That’s the thing about behavioural economics. What their studies seem to show is that people don’t learn from experience. If you’re stupid, you’re repeatedly stupid. You won’t learn. Most people are stupid. That’s the proposition.”
Passive is still growing relatively slowly
“(Active management) has been shrinking really slowly so, when Ken did his American Finance Association President’s Speech, one of the things he said was, we’ve gone from zero to 20 per cent in, I think it was about 40 years at that time, maybe more. Since then we’ve gone to 30 or 40 now that’s passive managed. So that’s permeated very slowly through the profession. Where it’ll go from there, we’ll see.”
Many “star” managers are really just lucky
“You take your 100,000 people picking stocks over a period of time. Then you pick out the one who’s doing the best and impute that to skill. The problem is, if I have 100,000 people picking, what’s the probability that one of them will be extraordinary purely on a chance basis? You’ll get a big outlier in that experiment. But that’s the way the newspaper accounts run: they look after the fact and they pick out the winners. So every year, for example, they pick out the best performers of the last five, ten years.
“Then you look at the following period (and there’s) no correlation between past success and future. How much persistence is there in performance? The answer is basically zero. The best predictor of future performance is fees and expenses.”
Genuinely skilled stockpickers wouldn’t work as fund managers
“There will still be a management business (in the future); it will just have very little active in it. You have to have some active investors to make prices efficient. The problem is, you don’t expect them to be professional managers because the logic of being a good investor is that you should get the returns, you don’t hand them back to other people. You take them back in higher fees — that’s the human capital activity of picking stocks or whatever in investment management. If you have real skill, all the returns should go to you, not your clients.”
Data on private capital is very biased
“The problem is: there are lots of good people studying that (area), but they’re hamstrung by the lack of good data. It’s all self-reported, so you get a very biased set of data. But it depends on what end of that business you go to. If you’re looking at managers who actually run the companies they buy, they may actually be able to add value, but that’s management value, it’s not stock picking value. If you’re picking companies that have a good idea but are poorly run, probably you can have a lot of value added in that case. But again, it should go to the guys doing it and not the investors. That’s the downside of that. That’s the logic of human capital, right?”
People see bubbles where there are none
“The way I interpret it is, you must be able to predict the end of it. A bubble has to be something with a predictable ending. People can’t identify bubbles that way. After the fact, it’s easy. There’s a famous story around about the early origins of market efficiency, in which Holbrook Working went into the faculty lounge at Stanford. He showed them charts of prices and said these were charts of commodity prices. And he wanted to see if they could identify bubbles in the prices and, to a man, they all could. The problem was: what he was showing them was cumulative random numbers. It was all just generated stuff. So the message is: people see bubbles where there are none.”
He refused to let news of his Nobel Prize disrupt his class
“I think they call at noon or one o’ clock Stockholm time — which is really early in the morning here. You never expect to get it because a lot of people could qualify to get it. The people here somehow had a guess because there were newspaper people at my door ten minutes later! And they wanted to come into my house. I said “No way!” I had a class that morning. I’d never missed a class in all the years I’d been teaching, and I wasn’t going to start now. I wasn’t going to let anyone in because the kids in the class were paying a lot of money to take that course. No way I wanted people disturbing it.”
… and Nobel Prizes are no big deal at Chicago anyway
“They had a big event here at the School (to celebrate) — a really big event with the news and everything. The next day, the Nobel people have a camera coming in, and they’re following me across the Harper Centre — the big atrium in the middle — and students are working along the sides, and we walked along the middle. Nobody looks up. So we get to the other side, and the television guy says, “Nobody looked up!” I said, “This is the University of Chicago: if they had to look up every time a Nobel Prize winner walked by, they’d get nothing done!””
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