Combining opposites produces a clear plan for investing

October 20, 2013 6:46 pm

Combining opposites produces a clear plan for investing

By John Authers

Nudging investment industry in right direction deserves a prize

It is now a week since the Royal Swedish Academy of Sciences announced that it would ask Eugene Fama and Robert Shiller to share this year’s prize for economics in memory of Alfred Nobel. At first, many wondered if the Swedish dignitaries had a sick sense of humour. The two are famous for taking opposite sides on whether markets are efficient. A more practical question might be: “What does it mean to say that markets are efficient or inefficient, and in any case what can we do about it?”The two economists shared the award with Lars Hanson of the University of Chicago, whose work in econometrics has not aroused the same public controversy.

Mr Fama, also of Chicago, promulgated the efficient markets hypothesis. It implies that beating the market is difficult because traders are already factoring in all known information. Meanwhile Mr Shiller, of Yale University, championed the application of psychology, and showed that in bubbles, markets could be deeply irrational.

Mr Fama’s work has been under attack for more than a decade. His own empirical studies show that small-cap stocks and value stocks (that look cheap relative to their fundamentals) outperform in the long term.

He attributed this to the extra risk involved in buying these stocks, which will eventually be rewarded; others believe he found persistent inefficiencies. He also found a “momentum” effect – that stocks keep moving in the same direction once a trend is established – which is hard to square with the notion of market efficiency.

More recently, Mr Shiller’s work has also come in for criticism. He used his measure of value, the cyclically adjusted price/earnings (Cape) ratio, to show that US stocks were wildly overpriced before the crash of 2000. But Cape failed to signal that stocks were compellingly cheap before the current rally in which US stocks have doubled in less than five years. Critics complain that accounting and tax conventions have changed too much to make Capes comparable over time, and that the Cape only shows buying or selling signals with hindsight, not in real time.

So the work of neither man is perfect. However, they have produced insights on which all can agree and which leave us with a far better idea of how to invest.

First, as Robert Jaeger of BNY Mellon points out, there are still no free lunches. Even in markets driven by emotion rather than rationality, it is very hard to find any opportunity to make money without taking a risk. It is easy to lose money in a bubble – think of the money managers who saw their clients leave them as they bet against internet stocks.

Second, prices are unpredictable, even if they are not random. A high Cape is good evidence that a market is likely to fall: it is of no use in predicting when it will fall.

Third, a standard stock market index, weighted by market capitalisation, is very hard (although not impossible) to beat. As is now widely known, most actively managed funds fail to beat their benchmark index over a long period.

That makes the case for index investing. Index funds, launched in the early 1970s, are often attributed to Mr Fama’s work.

However, ongoing research is revealing caveats. Studies now show that the more truly “active” a fund is, the better its chance of beating the index. And active funds’ performance before fees suggests that markets are not that hard to beat; a majority ofactive funds can beat the index before taking their fees into account – but this slips to a minority once fees are taken off. This implies that the work required to beat markets is too expensive to make the project worthwhile – but not that they are unbeatable. So the case for index investing rests on minimising costs, not the impossibility of beating the market.

Armed with these insights, we get a better idea of how to invest. First, index funds make much sense.

If attempting to beat the index, there are two choices. First, we can be daring and diverge from it, with concentrated bets. (Warren Buffett’s holdings look nothing like any index, and are not diversified.)

Second, we could minimise costs while finding a strategy that benefits from the imperfections that Fama and Shiller have discovered. Rigorously quantitative investing to exploit market inefficiencies – known as “smart beta” – makes great sense. And, like concentrated active investment, it keeps markets efficient.

Now we can see why the Swedes made a joint Fama-Shiller award. Several former Fama students are now successful quantitative active fund managers, using his principles – so a sensible reading of Fama shows markets are not unbeatable. Mr Shiller himself backs exchange traded funds that trade between sectors based on whether their Capes are high or low.

So the combined Fama-Shiller oeuvre gives a clear plan for investing, which is very different from the model once in force. Nudging the investment industry in the right direction deserves a Nobel.