Eugene Fama, King of Predictable Markets

October 26, 2013

Eugene Fama, King of Predictable Markets


Eugene F. Fama, 74, is one of the winners of this year’s Nobel Memorial Prize in Economic Science, along with Lars Peter Hansen, a fellow professor at the University of Chicago, and Robert J. Shiller, a professor at Yale. Often known as the father of the efficient-markets theory, Professor Fama, a former student of Milton Friedman, the University of Chicago Nobel laureate, is a careful empiricist and a genial, open conversationalist. But some of his opinions have set off controversies. He has come under criticism from Professor Shiller, for example, for minimizing the role of investor psychology and emotion in financial markets. And while Professor Fama doesn’t involve himself directly in politics, saying his “extreme libertarian” views are of no general interest, he isn’t reticent when asked about them. I interviewed Professor Shiller, a frequent contributor to Sunday Business, for an article last week. And on Tuesday, I talked by phone with Professor Fama for more than an hour. Here is an edited, condensed version of that conversation. Q. Gene, great to talk to you again. Congratulations.

A. Thank you, Jeff.

How are you celebrating? Are you getting out on the golf course these days?

Oh, yeah. I have a new hip; I’m a new man! If anybody ever tells you that you need a new hip, don’t hesitate.

O.K., I’ll keep that in mind. Now some serious business: help me explain your work and your views to people who don’t know them. Let’s start with the efficient-markets theory — or hypothesis, as you call it. What do those words mean?

Well, the general proposition is quite straightforward. It says prices reflect all available information. That’s it. The difficult part comes in developing tests of that idea, but the idea itself is quite simple.

Put that way, it seems like an insight that everyone has always had. But was that really a new thought?

You’re right, I didn’t invent the idea. Definitely not. I coined the terms “efficient markets” and “market efficiency.” You’ll find them in a paper I wrote in 1965. But those are just words.

What I did that was more substantive was I pointed out that you can’t test the hypothesis without also setting out what we call a “model of market equilibrium.”

What does that mean?

In simple terms, it’s this: you’ve got to ask what is the market trying to do in setting prices. In more detailed terms, what it says is: tell me something about how to measure risk. And then tell me, what is the relationship between the expected return on an asset and its risks. It’s a combined problem, something I call the “joint hypothesis problem.” You’ve got to test them together. And testing all of that is where it gets tricky.

The idea is that market prices in the short term don’t have a predictable direction. One implication of this thinking is that it’s very hard to beat the overall stock market, which is an argument for low-cost index funds as opposed to active management. True?

Yes. That’s right.

But then your own research undercut some of this. When you looked closely, you found that markets were more complicated. You looked at bond returns, and found that there actually was some predictability, right?

Yes! And Shiller and I and lots of others wrote papers and found a similar phenomenon with stock prices.

You found some factors that may help to predict longer-term stock prices.

Well, yes, take something like the dividend-stock price ratio. When it’s high, expected stock returns tend to be high, and when it’s low, expected returns tend to be low.

And then Ken French [a Dartmouth economist] and I wrote a paper saying that for both bonds and stocks, there are several variables that affect prices, all of which are highly related to business conditions. We concluded that it tells us that it’s likely that the variation in expected returns is rational.

Richard Thaler, your good friend at the University of Chicago, and Bob Shiller, your fellow Nobel laureate, take a different view.

The people on the other side say, well, not so quick! The variation in expected returns — even if it’s related to business conditions — can be irrationally related to business conditions.

So which is it, rational or irrational? Do you know?

Well, at that point, you cannot tell the difference anymore between the behavioral and the rational explanations.

Shiller and Thaler helped to found the field of behavioral finance to help explain a lot of these anomalies. Where’s the difference between the two views, as you see it?

If I were to characterize what differentiates me from Shiller or Thaler, it’s basically we agree on the facts — there is variation in expected returns, which leads to some predictability in returns. Where we disagree is whether it’s rational or irrational. And there’s nothing in the available evidence that allows one to really settle that in a convincing way. The stuff that both Shiller and I have done has been very illuminating in terms of the behavior of returns. The interpretation of that is open for reasonable disagreement.

I think all points of view should get a full airing, and that’s why I’m thrilled to get the prize with Shiller.

That’s a great summary.

But all of the common asset pricing models are based on the concept of market efficiency. That’s the other part of the story.

I’ve spent a good part of the last 40 years testing those models. And a result of a lot of that is the so-called Fama-French three-factor model. It’s widely used both by academics and in industry. [He chuckles.] I’m laughing because the theoretical basis for the model is quite shaky. Basically, we saw these patterns in returns and our motivation was to try to explain them.

Unlike Shiller, you believe there’s a rational basis for all this stock behavior. What are the three factors, as you see them?

The spread of the market return over the Treasury bill rate is one factor. The second is the small-stock factor — the difference in the returns of small stocks and of big stocks. And then there’s the so-called value-growth factor, which is the difference between a diversified portfolio of value stocks versus growth stocks.

Your research has played a big role at Dimensional Fund Advisors, which has become a major asset management company. You were there at the beginning, weren’t you?

Oh, yes, I’ve been on their board since their first day, and my work is embedded in a lot of their products, sure.

Now let’s focus on a few other touchy subjects. Bob Shiller has been recognized by the Nobel committee for his work on asset bubbles. But if I ask you what caused the financial crisis — was it an asset bubble, a real estate bubble — you’re going to tell me you don’t even know what a bubble is. Is that right?

[He laughs] Yes! Absolutely right!

Now let me ask you, have you ever testified before Congress or given policy advice to political figures?

No, I’m too unpredictable. I don’t give advice like that. I don’t believe anyone wants to hear what I have to say.

Why’s that?

Well, I’m an extreme libertarian, but I realize we’re in a democracy, and in a democracy people can have views of all stripes and there’s no reason to argue about it.

Well, you’re a Nobel laureate now and people are curious about your views. For example, whenever we talk you always seem to be rereading “The Road to Serfdom,” by Friedrich Hayek. That’s an important book for you, isn’t it?

Yes, it’s a great book. It’s a philosophy, of course; it’s not empirical. What Hayek is basically saying is that to the extent you let government take over economic activity you’re basically giving up freedom, and I think that’s a point Milton Friedman made quite emphatically throughout his lifetime.

I consider myself closer to Milton in my thinking than to anybody else. And Milton was also an enthusiastic libertarian.

Do you accept the basic teachings of John Maynard Keynes, which tell us that government should spend more to counter the effects of a recession?

No, I don’t think there’s a lot of empirical evidence that Keynesian spending really helps.

Despite his advocacy of smaller government, Hayek believed in a social safety net. Do you?

Yes, he did, and I have a similar view. I think we need Social Security, things like that.

And, of course, people don’t entirely understand how risky investing is. That’s very important to get across. We don’t really know if the stock market will produce the returns in the future that people expect. Statistically, you can’t show that it will. There’s real risk there.

Do you believe in financial regulation?

Of course, some regulation, yes. You need a level playing field, you need the government to step in sometimes. But I think we’ve gone too far with Dodd-Frank.

In the financial crisis, do you think the government should have bailed out the big banks?

No, I don’t. I would’ve favored nationalizing the banks, not bailing them out.

Really? That’s not very libertarian, is it?

Well, we’re talking about realistic alternatives. It’s not credible that in a financial crisis, the government will do nothing. It never has. There are going to be demands for it to do something. So you’ve got two choices now. Nationalize them or bail them out. Bailing them out gives them terrible disincentives; it encourages them to take risks because they’ll be bailed out. So I’d nationalize them — and clean them up and then reprivatize them.

So would you have favored that the government do nothing at all?

I said at the time that it would be an interesting experiment. But what people argue is that it would be quite destructive, that it would create long-term problems. We don’t know that that’s true, but I think it’s kind of moot because it’s not an experiment that’s ever going to be run.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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