What can you learn from Mr. Efficient Markets now?
It had all the appearance of a market anomaly. For 25 years the world’s leading academics in the field kept predicting that Eugene Fama was certain to win the Nobel Prize in economics. If this year wasn’t Fama’s year, the talk always went, it would come soon. In an efficient market like the one Fama champions for stocks — where what most people expect to happen is the best forecast of what will happen — Fama would have won long ago. It didn’t happen.
Then, after the crash of 2008, Fama’s Nobel chances appeared to dim. The way that investors had dumped stocks in a seemingly emotion-driven panic during the financial crisis appeared to contradict Fama’s view of an ultra-rational world. “After 2008 my brand of finance got a bad rap,” says Fama, seated in his glass-framed, aerie-like office overlooking the Rockefeller Memorial Chapel at the University of Chicago’s Booth School of Business, where he has been among the most influential faculty members for some 50 years. “The criticism was based on a gross mischaracterization of my work. After the crash, I never thought I’d win the Nobel Prize.”
But the Nobel market finally reverted to the mean. On Oct. 14 at 6 p.m., Fama, 74, was named a 2013 laureate in economic sciences, along with Robert Shiller of Yale and Lars Peter Hansen, a University of Chicago colleague of Fama’s. Fama’s stock may have dropped after the crash, but the financial world’s appreciation of his revolutionary, enduring ideas quickly reasserted itself, and his true value was finally rewarded. As someone who has known Fama for more than 40 years and was heavily influenced by his thinking, I was gratified to see his work honored.
Fama won the Nobel for pioneering the efficient-market theory. It states that markets absorb new information so quickly and accurately that it’s virtually impossible to beat the averages without taking lots of risk. Fama developed the hypothesis a half-century ago, and he’s stuck by it ever since. But his thinking has evolved, and continues to evolve, in surprisingly radical ways.
Over the years Fama has endorsed several “risk factors” — others call them major gaps — in efficient markets. These are categories of stocks that appear to defy the overall market efficiency to deliver exceptional returns over long horizons. Building portfolios around these risk factors can make investors, from the 401(k) crowd to big pension funds, a lot of extra money. In fact, Fama himself has capitalized on those investments to make a fortune for himself in his role as a leading adviser to one of the world’s foremost asset-management firms. Understanding Fama’s evolving view of the market is one of the most valuable, practical guides for today’s investors.
Fama’s ideas may have received the ultimate validation, but they’re still highly controversial. In fact, his fellow laureate Shiller has an almost diametrically opposite point of view from Fama on what moves the markets. (Lars Peter Hansen isn’t at odds with either; he earned the Nobel for developing econometric models showing how investors’ appetite for risk and their expectations for future returns vary drastically in different periods.) Shiller strongly disagrees with Fama’s view that rational behavior drives the markets, insisting that fear and mob psychology is often the main cause of big swings in prices. In early December, Shiller warned in an interview in Der Spiegel that a new bubble could be developing in U.S. stocks. “I find the boom in the U.S. stock market most concerning,” he said.
Nonsense, says Mr. Efficient Markets. The mere use of the term “bubble” makes Fama see red. He says asset price bubbles simply don’t exist. Fama argues that when stocks crash — as in the dotcom crash or the cataclysm of 2008 — it is caused by a perfectly logical fear that a depression might follow. Can there be such a thing as an efficient panic? Fama’s extreme view on the topic elicits disagreement from fans who think he’s mostly correct. “In my opinion, there’s no way that rational behavior caused the tech craze of 2000,” insists Cliff Asness, a former Fama student and co-founder of AQR Capital, a $90 billion asset-management firm. “It was a bubble, pure and simple.”
What everyone can take away from Fama’s work is that markets are mostly efficient, though maybe not as nearly perfect as Fama insists. And by spending a career documenting how these powerful processors of information are far more right than wrong, Fama has perhaps done more for individual investors than any other economist of the past half-century. “The efficient-market hypothesis is the North Star for everything in finance,” says Asness. “One of the implications of his research is that every manager must be measured against a passive index to show if they’re really successful, and almost all fail over time.”
In that sense, Fama is the intellectual father of today’s index fund industry. He’s been developing new product after new product for Dimensional Fund Advisors, one of the world’s first and most successful managers of passively managed portfolios, since its launch in 1981. “Gene thinks great thoughts, and we build businesses around them,” says DFA’s CEO David Booth, a former pupil of Fama’s who in 2008 donated $300 million to the school that now bears his name.
Fama’s research wasn’t the only wellspring for index funds. John Bogle, founder of Vanguard, created the groundbreaking Vanguard 500 Index Fund (VFINX) in 1975 based on the findings of MIT’s Paul Samuelson, who also charged that active managers couldn’t beat the averages. Today Vanguard manages some $2 trillion in assets.
Fama coined the term “efficient markets” in a 1965 paper shortly after joining the University of Chicago’s business school faculty in 1963. “At the time, the entire finance field concentrated on securities analysis, how to pick supposedly undervalued stocks,” recalls Fama. The then 26-year-old economist challenged conventional thinking with his efficient-market hypothesis. In the paper he argued that market prices are always “right” in the sense that they represent the best estimate today of how shares will perform in the future. As long as all investors get the same new information at the same time, neither extra smarts nor more luck will earn you extra returns over the long run. The overall market is a fabulous discounting machine, Fama contended, that handicaps future performance far more accurately than do active investors. The concept was shocking. It maintained that, contrary to virtually every other human endeavor, amateurs could easily beat professionals who pick individual stocks — in this case by merely following a passive index.
Fama’s views quickly won acceptance among academics — and scorn from money managers. “They brushed us off, and they still do,” says Fama. “I’d talk to reporters and they’d get it all backward.” Fama explains that active managers compete against other active managers, so that for every winner there’s someone who loses an equal sum. “So it’s a zero-sum game before expenses and fees, and a negative-sum game after them,” he declares. “For investors, it’s not a good game.”
By contrast, index funds don’t compete with active-fund managers; they simply follow an entire index and save mightily on fees and trading costs. In a 2010 paper with frequent collaborator Kenneth French of Dartmouth, Fama found that around 65% of the more than 3,100 mutual funds studied underperformed passive portfolios of similar risk in the long run. “And the investors who generate big returns over five years, the guys they write books about, are supposed to keep winning, right?” says Fama. “Well, they don’t.”
Fama took a highly unusual route from blue-collar Boston to the rarefied world of academic finance. Along the way, he’s displayed fierce intensity in his twin obsessions: research and sports. For Fama, the ideal is to be exercising either your mind or your body at all times. “He’s skated his way through about every sport you can name,” says Robert Aliber, a retired Chicago professor. “He’s not always skillful, but he’s always incredibly competitive.” Fama, who spends part of the year in California, used to call himself probably the best windsurfer over 50 in the world.
When I was a student in the business school at the University of Chicago in the 1970s, I used to play tennis regularly with Fama on the soft courts at the faculty club. Not surprisingly, Fama exhibited a singular style: He served right-handed and hit ground strokes left-handed — most of them, as I recall, lobs that seemed magnetized to the baseline. Fama played with a T2000 metal racket, and his miss-hits sounded like minor car accidents. “I still have the scars from when I’d gouge my legs with the wire holding the frame!” says Fama.
A hip replacement has sidelined Fama from tennis and windsurfing, at least for now. His new love is golf. He gives his handicap as nine, but adds that an adjustment might be needed for his novel approach to putting. “Putting isn’t a manly pursuit,” he allows. “I never take more than two putts, and if I haven’t holed a putt, I stop counting.”
His approach to work is a study in disciplined scheduling. “He has one speed, and it’s ‘on,’ ” says Booth. Fama rises at 4:30 a.m. and starts his day by blasting Verdi operas on his stereo. He works six hours a day, 365 days a year, going to the office every Saturday and Sunday. That leaves time for sports in the afternoon. “It’s amazing what you can accomplish working every day of the year,” says economist John Cochrane, Fama’s son-in-law and a colleague at Booth. Fama doesn’t waste time with niceties either. He’s all about the facts and the data. “He’s a taciturn man of few words,” says Asness. Two- to four-word emails are a specialty, with blunt replies like, “This is nonsense!”
Fama grew up in Medford, Mass., a working-class Boston suburb, in a two-flat — a modest building with a common entrance and separate residences on each floor that his family shared with his uncle’s clan. His grandparents ran a grocery store, and his father drove a lumber truck. At Malden Catholic High School, the wiry, 5-foot-8 Fama finished second in the state high-jump competition and starred as a halfback in football. One of the cheerleaders was Sallyann Dimeco. He hitchhiked to school and was frequently left off in front of Sallyann’s house. “We’d walk to school together,” he recalls. They’ve now been married 55 years, and they have four adult children and 11 grandchildren.
The future economist was the first in his family to go to college. At nearby Tufts University, Fama started in Romance languages in 1956 and planned on becoming a high school French teacher and coach. Soon, though, he became “bored with rehashing Voltaire.” His first encounters with economics courses and professors, on the other hand, left him so enthralled that he envisioned a career in academic finance. He ended up at the University of Chicago, a heavily quantitative institution where adventurous older professors, notably Fama’s mentor Merton Miller, as well as a group of young rebels — led by Fama, Myron Scholes, Fischer Black, Michael Jensen, and Richard Roll — would reinvent corporate finance.
From the start, Fama prided himself on combining theoretical thinking with rigorous testing to see if the big ideas worked in the real world. “He’s always been an empiricist at heart,” says Cochrane. “He always endorses what the data shows and adjusts his models to incorporate the findings on how stock prices actually behave.”
In the 1970s Fama worked with the famous capital asset pricing model (CAPM) to explain why certain stocks and groups of stocks generate bigger returns than others over long periods. CAPM, originated by Nobel winners Harry Markowitz and William Sharpe, deploys a statistic called beta to measure a security’s volatility compared with fluctuations in the overall market. Beta was thought to explain both outperformance and underperformance of individual stocks. If a stock falls more than the market in a bust and rises more in a boom, it has a higher-than-average beta and hence must offer bigger future returns for an investor to buy it. In short, a high beta means a risky stock. The fat returns on those stocks, Fama and others concluded, were simply the reward investors required for shouldering beta-style risk.
“The idea was that stocks can only earn a higher return if they have a higher beta,” says Roger Ibbotson, a student of Fama’s who later founded a leading data service for stock prices, Ibbotson Associates. But starting in the 1980s, proof emerged that one category of stock after another beat the markets over time, and did it without exhibiting any more volatility than the overall market, or not enough extra beta to explain their superior performance.
This is where Fama’s thinking changed in ways that made a gigantic contribution to money management. It was Fama, along with frequent partner French, who did the best real-world testing on a series of apparent efficient-market exceptions to establish that they really did beat the market. In each case, the sequence of events was similar: Fama would initially think that these apparent anomalies, sometimes proposed by his own students, didn’t really work. He’d then run his own independent tests, with French as his partner. Once convinced of the exception’s validity, he would enthusiastically endorse the new strategy and help develop a DFA product to exploit it. Those strategies would then quickly spread to the wider world of investing.
The first seeming exception to the efficient-market hypothesis arose from a study of small-cap stocks. In 1980, Rolf Banz, a Fama Ph.D. student, told Fama his research showed that the stocks of companies with small market caps outperformed the overall market over a long horizon. “This was the first crack in the best of all possible worlds, where CAPM had worked so well,” recalls Banz. “I had the misfortune of being the first one to question the faith.” At first, Fama was more than skeptical. “I wouldn’t say he was hostile, but he wasn’t particularly enthusiastic or encouraging,” recalls Banz. Fama forced Banz to test his results to what Banz calls “the breaking point.”
To his credit, Fama allowed the data to triumph. By a remarkable coincidence, in 1981, Booth and his partner Rex Sinquefield were launching DFA. The idea was to develop index funds of small companies, since investors then had virtually no choices if they wanted to buy baskets of stocks in the category. “It was originally a diversification strategy,” says Sinquefield. “We asked Gene to be an investor and director, and he said yes. Then he said, ‘I’ve got a Ph.D. student whose thesis shows that small-cap companies outperform.’ ” Banz’s findings became a powerful sales tool for DFA, and Fama helped design the company’s small-cap funds.
The next breakthrough caused an even bigger upheaval. The concept that value stocks — downtrodden, unloved companies with low price-to-book or price-to-earnings ratios — delivered far better-than-average returns was nothing new. It dated back to the writings of Benjamin Graham and David Dodd in the 1940s. But convincing, scientific testing was needed to prove it.
In the early 1990s, Fama and French ran the definitive test on value stocks, concluding that, over long periods they handily beat the overall market. The margin from 1926 to today is around three percentage points a year for large-cap stocks. Beta didn’t explain the outperformance. As it turned out, value stocks were less sensitive to market moves — meaning by some measures less risky — than the average stock. Armed with their findings, Fama and French helped design new value portfolios for DFA in every conceivable category of stocks: U.S. small-cap and large-cap, international, Europe, Japan, etc.
As a result of the findings on small-cap and value stocks, Fama abandoned CAPM as the explanation for why certain categories of stocks do far better than the market, without more apparent risk to most people. In 1993, Fama and French, to use Fama’s term, “dethroned” CAPM with their new brainchild — the so-called three-factor model. It used three measures to effectively redefine outperformance: the value effect, the small-company effect, and sensitivity to the market.
The three-factor model became the gold standard for measuring the performance of money managers. No longer could managers claim they were “outperforming” if their value stocks beat the overall market. The new benchmark for outperformance was the correct one. Did a value fund outpace the value index? Did a small-cap fund best the small-cap index? The three-factor model revealed that after fees and compared with the proper benchmark, the active crowd were almost always trailing.
In the mid-1990s Cliff Asness, then Fama’s Ph.D. student, found another apparent exception to efficient markets — the momentum effect. This theory contradicts the concept that, in an efficient market, higher returns must be accompanied by higher risk. Asness found that, for up to a year, companies that perform well or poorly tend to follow the same course, without showing extra volatility. AQR Capital now incorporates momentum into the strategies behind many of its funds.
Perhaps the biggest challenge to the efficient-market hypothesis, however, came out of Fama’s own research. His analysis of the so-called risk premium for stocks has evolved and caused him to break with his own past beliefs about the overarching concepts that govern markets. Today the topic remains the leading zone of conflict between the rational and behavioral schools, between the followers of Fama and Shiller. It’s important to carefully assess the arguments, because they present two divergent views on whether it’s wise (Shiller) or foolhardy (Fama) to time the market when stocks appear extremely cheap or expensive.
Fama and Shiller agree that the valuation of stocks compared with earnings and dividends provides a good forecast for how stocks will perform in the future. In his early formulation of the efficient-market hypothesis, Fama thought it most likely that investors wanted pretty much the same returns in most periods, good or bad. It appeared that when price/earnings ratios for the entire market were extremely high, the investors were simply expecting a surge in future earnings and dividends. In other words, a big, anticipated improvement or deterioration in the fundamentals explained why market P/E ratios were high or low.
In research published in 1988 and 1989, however, Fama and French changed course. Their research showed that predicted changes in profits and dividends, the fundamentals, don’t explain the often wildly seesawing course of the market at all. Nor do changes in interest rates come close to explaining them. The fluctuations come mainly from big shifts in what’s called the “equity risk premium,” or the extra cushion investors demand for owning stocks instead of more stable government bonds. Instead of remaining pretty flat, as might be expected in an efficient market, the risk premium jumped all over the place in the Fama-French research. “In the short term most of the moves in prices comes from changes in the risk premium, not in cash flows or dividends,” says French.
Seated in his office, in front of a built-in blackboard filled with equations, Fama explains why this conclusion fits generally with his efficient-market theory. The risk premium — and therefore prices — swings around so much for two reasons, he explains. “First, people think rationally that the world really is more risky,” he says. “Imagine in 2008 that investors thought there was a 10% chance we’d have a depression. That would partly justify the drop in prices.” The second reason: Once people have lost a lot of money and begin to imagine more losses ahead, their “taste” for risk evaporates. “Both things happen,” says Fama. “The risks can go up, and the willingness to bear risk can go down.”
This mostly happens, Fama and Shiller agree, in periods of big economic stress — for instance, in times of bust like the recession of the early 1980s or the housing-related financial crisis of 2008. They also agree that when valuation measures drop far below historical averages, the expected returns are far above average. But that’s where their agreement ends. Shiller argues that a huge drop in prices isn’t rational at all. Investors, he claims, are simply reacting with their gut and getting the future all wrong. In tough times they panic, fearing that the world, and the fundamentals, will get far worse than they have any real chance of being. So that’s the time to buy, says Shiller.
Fama says it’s better not to time the market. “Market timing doesn’t work,” he says. “If all the bubbles and all this mispricing really exist, how come so few people see it before it turns out that way?” Even so, Fama acknowledges that low dividend yields do predict future gains with pretty good probability. So what does he think about the market’s paltry 2% dividend yield today? “It’s most likely that stocks will post lower returns than the average of five percentage points over T-bills historically,” he says. It’s likely that Fama and Shiller will tangle over the wisdom of market timing for years to come. The safest course is for investors to concentrate on index funds focused on areas that beat the market without adding risk: small-cap, value, and momentum stocks.
As if to prove he’s not slowing down, Fama recently endorsed a promising new strategy. He’s long reckoned that companies that post high profits year after year should keep repeating, and hence outpace the overall market. Recent research by Robert Novy-Marx of the University of Rochester made the case for this “profitability” factor, and Fama and French tested it exhaustively. Their blessing led to the creation of the first “growth” funds in DFA history, a suite of four funds ranging from the International Large Cap Growth Portfolio (DILRX) to the US Small Cap Growth Portfolio (DSCGX). In a mostly efficient market, the funds can be expected to outperform their benchmarks over the long term.
Near the end of our conversation, I pose a question to Fama. In his view, active money management is driven by runs of pure luck that investors mistakenly misinterpret as skill. So how does he explain that investors still entrust around 80% of the money in mutual funds to active managers? Is it possible, I ask him, that emotion and irrationality — the hallmarks of the behavioral school of finance — are far more powerful in explaining why folks are irrationally attracted to stock-picking managers than in explaining why stocks actually move? Fama shakes his head, chuckling. “I don’t know the reason why active management is so dominant,” he says. “At this stage, I find it completely puzzling.” And inefficient.