Last week’s award of the Nobel Prize in Economics to Gene Fama recognizes work that investors can directly use to improve their outcomes. Fama shares the distinction with Lars Peter Hansen and Robert Shiller.
Fama, often considered the father of modern finance, is Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago, a director of Dimensional Funds Advisors, the author or coauthor of over 100 published papers and one of the most cited academics in finance. It’s no exaggeration to say that Fama’s work has revolutionized the way we think about markets, risk and return, and how to build more rational portfolios.
Fama’s work on efficient markets, the term structure of interest rates, the Fama-French Three Factor Model, and more recently his work on profitability have contributed immensely to our understanding of how markets work and how we can use markets to benefit investors.
Fama’s insight that active management by either individual security selection or attempts to market time are unlikely to add value led to the rise of index and asset class funds that passively construct broad market exposure. In other words, monkeys throwing darts can do a better job than the “experts”. So, why pay experts?
Markets are “efficient” because so much information is available in almost real time that millions of investors almost instantly reach a consensus. Active managers are unlikely to gain sufficient additional insight that will recover the cost of their research and trade execution.
Additionally, while investors can find all kinds of patterns in past return data, none of them will be any help in forecasting future performance. Fama’s experience as an undergraduate researcher for an investment advisor utilizing charting led him to the conclusion that the exercise was totally useless. He found lots of patterns and signals in the data looking backwards, but none held up going forward.
Fama never postulates that the market price is right, only that it’s the best price available. It’s extraordinary difficult to consistently find mispriced securities or profit from market timing. Bets against the efficient market rarely pay off over time.
In the real world the market efficiency is conclusively supported because passive funds invariably dominate actively managed funds by generating higher returns, lower costs, greater tax efficiency and lower risk. So, while it’s highly unlikely that any particular investor will outperform the market, index and other passive funds give us a foolproof way to capture market returns. And market returns are very lucrative.
Capital Asset Pricing Model (CAP-M), Bill Sharpe’s explanation linking risk and return was a brilliant insight without any supporting data. In the center of the market it worked pretty well explaining both stock prices and investor returns. But, for parts of the market it just didn’t hold up. In particular small and value companies had consistently higher returns than their risk could explain. (Value stocks are cheap relative to their earnings, and generally have some degree of financial distress.) An entire cottage industry of economists tried to make it work by adding on various other generally unsatisfactory explanations.
Fama and Ken French of Dartmouth College took another approach. They sifted through the mountains of data to find additional factors of return that might better explain what everybody was seeing. It turned out that investors are concerned with risk factors other than just volatility. In particular they demanded higher returns for small companies and value companies. As a result, the pricing mechanism drove down the securities’ prices until investors willing to hold them could expect higher returns going forward. The addition of the two factors to the CAP-M greatly improved the model and has become the generally accepted explanation for returns and security prices. Significantly, the model points a path to higher than global market returns for investors who are willing to tilt their portfolios to capture those incremental gains.
More recently Fama and French turned their attention to teasing out the impact of profitability on stock retuns. Everybody knows that firm profits drive stock prices, but no one proposed a proxy for profits going forward. As it turned out, if a company is profitable this year it’s highly likely to be profitable for some time in the future. So, if you had companies with the same size and value characteristics but some were more profitable than others, you could expect higher returns from the more profitable firms. In retrospect this seems evident. When he was asked in a seminar why no one had investigated this earlier, he remarked that, “We were lazy”. Again, this insight directly opens up the possibility of higher than market returns for investors that capitalize on the research.
Fama’s world is populated by Spock like investors making fully rational decisions based on freely available data. It’s immensely valuable but doesn’t fully reflect the messy real world of global markets. It simply doesn’t compute to Fama that markets might be efficient but individual investors might be grossly inefficient.
So, it’s a little ironic that Fama shares the Nobel Prize with Robert Shiller of Yale who has been interested in economic cycles and asset pricing bubbles, and a father of behavioral finance along with Richard Thaler. Fama is openly dismissive of behavioral finance which studies how individuals make often flawed decisions. In his view, investors react or overreact in random ways to information which cannot be predicted, and therefore there is no way to capture any benefit from their foibles.
Thaler who is another giant of modern finance has an office just a few yards from Fama’s at the University of Chicago. They are not close. According to Fama, “It’s great work, but there is nothing there”. Such are the egos at work at the very top end of academia.
Like many academics that cycle “from gown to town” Fama brings the benefits of his research to a commercial enterprise. As a director and consultant to Dimensional Fund Advisors he’s applied his academic findings directly to real world applications to the great benefit of institutions and the clients of independent investment advisors.
Disclaimer: The author holds DFA funds for his personal portfolio and utilizes them extensively for clients.