Eugne Fama Jr.

Eugene Fama, Jr. on Efficient Markets

Eugne Fama Jr.

On December 10th 2008 Index Funds Advisor's President Mark T. Hebner interviewed Dimensional Fund Advisor's Vice President Eugene Fama Jr.


MH:
Hi, I am Mark Hebner, President of Index Funds Advisors.  We’re really excited to have Eugene Fama, Jr. with us here today. Eugene is the Vice President of Dimensional Funds Advisors.  Eugene is famous among the advisor community for taking his Dad’s work (who is Eugene Fama, Sr.) and sort of making cartoons out of it so that the rest of us can understand this.  And as someone visiting ifa.com we are pleased to bring him to you to explain some of these difficult concepts for investors.

Eugene Fama, Jr. Explains the Efficient Market Hypothesis
MH:
Eugene, your father is famous for developing what’s called the Efficient Market Hypothesis. Maybe you can put in your own words what that actually means.
EF:
A lot of people think what it means is that all of the information about everything is known by every investor and therefore prices of securities and prices of stocks are always perfectly right. That’s not actually what it is. It actually means that everybody making multitudinous decisions (the buyers, sellers and analysts in the market) everything they know in combination is already in the prices to such an extent that no single participant in the market can outperform more than you could really expect by chance and do it persistently, that’s basically the idea. So an efficient market is really just one that nobody can beat regularly by making better guesses than what prices are indicating.
MH:
So under those conditions would we think that prices are fair most of the time?
EF:
Yes they are, and where they are not they’re kind of randomly unfair. So that all it really requires is that you can’t take advantage of it right? So if you don’t see people taking excessive profits out of the market by outguessing everybody else than you can assume that markets are working fairly well. And the evidence for this is all around us. Look at the capitalist system. What has done a better job of allocating resources in modern human history?  It has created so much economic growth, so much wealth, and capital investors share in that by putting their money to work in the capital market. So the good news about market efficiency is that it kind of relieves us from having to be smarter than everyone else. The market is designed to compensate us for taking risk.

Eugene Fama, Jr. Explains Multifactor Investing
MH:
The other important concept about understanding investing is what is sometimes called the Asset Pricing Model. If we go back to the 1960’s Bill Sharpe came out with what he called the Cap M and then later Fama and French sort of modified that with what they called their Three Factor Model for Equities and another Two Factor Model for Fixed Income. Maybe you could expand on that a little bit and give us your sense of what that all means.
EF:
Well, asset pricing is sort of a specialized field of finance where they are actually trying to find unique differentiated ways that markets compensate investors. So it’s about segments of capital markets that have their own risk-return characteristics. In other words it’s really about asset classes, the way we talk about them properly (pieces of markets with their own performance). Single factor model says basically that all performance is driven by how much relative risk you took to the market itself. So if the market was up by 1 on average or down by 1 on average and you were up by 1.2 or down by 1.2, you’re a 120% taker of market risk and so your expected return was 120% of the markets average return. The Three Factor Model is basically the same concept, except it deepens our understanding of what kinds of risk investors get compensated for. In addition to how much stock market risk you take there’s a risk associated with size it turns out. In other words, small cap stocks are riskier than large cap stocks and they have a higher expected return to compensate investors for that risk. And then stocks with low relative prices like values stocks are riskier than growth stocks, and they have a higher expected return as a result of that. So the way to think about the Three Factor Model is that it is sort of a retooling of the first asset pricing model from the early 60’s and it really captures a lot more of what investors care about and what drives investment performance overall for portfolios.
MH:
Now we’ve heard various estimates as to how much of the returns are explained by the Three Factor Model. What’s your current estimate on that?
EF:
Most returns are explained by the Three Factor Model.  We’re looking in our studies that about 97%-98% of returns are not being driven by manager skills or that a person actually timed well or picked the right stocks, but rather by how much each person differed in terms of their exposure to stocks in general; to small cap stocks and to value or growth stocks. These are the real determinants and it basically explains the lion’s share of everything there is in investing and the funniest thing about it is that the 96%-97%  going with that and the other 4%-3% that is left over is unexplained which is generally attributed to idiosyncratic behavior of the management, in other words, choices they made trying to outguess everyone else, and that number is negative.  So in other words, the 4% that is due to manager activity, of the traditional variety is actually taking money away, is actually a negative. 
MH:
So basically we are explaining all of the returns.  So under those conditions, investors are really concerned with how much risk they take rather than guessing what manager and what stock to choose or time to be in the market.
EF:
That’s exactly right.  In theory, in the market you wouldn’t get compensated for any individual stock and the good or bad luck that happens to it, you are compensated on more of a system wide societal level and the risks that affect all the stocks like the risks we are experiencing right now with all the stocks, it affects everybody.

Eugene Fama, Jr. Explains DFA's Unique Trading Secrets

MH:
One of the reasons that we like to advise that our clients invest with Dimensional is that Dimensional has taken indexing to what I call another level, above what the traditional indexing firms have done and I think you’ve done that through different designs of trading and asset classes and maybe the trading thing in particular is something quite unique to you guys, butcher block trading for example, and maybe you could take a minute to talk about some of the uniqueness of how you manage your dimensional indexes.
EF:
That’s a great question.  At DFA we are not really so concerned with mimicking any establishments as a benchmark because we actually believe that academic science discovers through assets pricing these different asset classes so we would never turn to a big index vendor and copy their portfolio robotically,
MH:
Like S&P 500 or Russell.
EF:
Right. We wouldn’t want to do that, we actually think we have a more precise way of determining what the overall factor is and when you get into some of these portfolios of maybe small cap stocks you’re talking about thousands and thousands of names and it just sort of occurs on a cursory level and that it doesn’t make sense to actually try to hold all those names in exact proportion along with an index and to trade along with that index because it turns out that that is very expensive to do.  See the actual thing that distinguishes our methodology in terms of trading most precisely from the traditional money management forms of doing this is we trade on price rather than on time.  Let me explain that, an index manager is going to hold all the securities in the index in exact proportion to how the index holds them when the index holds them. So they are not indifferent about time and they actually have to get in and out of securities when the index does.
MH:
When it’s announced.
EF:
Right, so they have a time they have to trade by and any price issues are actually secondary to trading at that time interval.  Now the same thing goes for active managers, they believe that something is going to happen next year, next month, next week, and the stock is going to go up or down and that actually makes it so that they have to make a decision based on time as well.  We don’t believe that we can predict the future so that takes time out of it in a sense.  We don’t believe we have to track an index because we have these academic views of what the asset classes are and that takes time out of it as well so what we can really do is say there are thousands of small cap stocks here, stocks that are tiny and we do want to hold them in proportion in general but we’re willing to randomly allow their weights to be heavier in the index but we’re willing to hold a little less in the index if we can get better execution, if we can get prices and transactions on these things that aren’t full of trade impact costs.  When you’re forced to trade by a certain time that tends to be very expensive.  So we can create what I call a creative indifference that we have thousands of securities across which we are pretty much indifferent and that gives us a real opportunity to shop for the best deals in that moment and be more flexible than a traditional manager indexing or active. 

Eugene Fama, Jr. Explains Block Trading

MH:
So one of the elements of your trading strategies is called Block Trading, maybe you could just expand on that a little and explain to our viewers what Block Trading means.
EF:
Block Trading means basically that if you come to market and you are looking to buy securities to populate a portfolio well there’s people on the other side of those trades and a lot of them are institutional investors that are holding big amounts of a single name of a small cap stocks because they are undiversified active managers that are picking and choosing stocks but these tiny stocks that trade rather infrequently, they are not like big companies that are constantly trading everyday, it might take a long time for somebody that wants to sell off a position to sell it in the open market so we have always been there to say that if you need to unload a huge amount of this stock in a hurry, that we’ll buy it but we want a discount for buying it.  And that is part of this whole philosophy in that we are saying that we don’t believe that the thing that is motivating that active manager to dump the stock is true, we don’t think his prediction is right because the end result if he were right would be that we were systematically buying losers because we would be buying the things all these experts don’t like and we would have ceased to exist a long time ago especially in the early days when we did the highest percent of our portfolio in blocks.  So blocks themselves and the fact that block trading has been sort of a kind of intelligent and successful way to trade illiquid  portfolios is secondarily a great piece of evidence that active managers who are supposedly experts in some of the most under researched and supposedly inefficient parts of the market are wrong about what they are buying and selling.  Which I think is the better part of the story myself, I think that’s the fun part.
MH:
What is the typical discount if someone wants to unload some big block to you guys and you earn a liquidity premium because you are making that guy liquid on the other side of the trade.  What is typical there as a percentage below some price; 3% - 4% or something like that?
EF:
Well, I think that it changes, something like that and it is not really as much as it used to be honestly, one reason is that the market is becoming more computerized and people are trading small cap stocks a little more than they used to and liquidity is a little more there and there are a lot more small cap managers but also the portfolios that we buy small cap then have so much leverage to buy across so many different things and they are so large that the actual percent of the blocks that we buy of the total is lower, but don’t get me wrong, you do not actually have to transact the blocks to secure discounts.  Let me put it this way, you don’t have to trade blocks to show a premium in return over index funds.  All you have to do is not trade along with the index funds because the index funds subtract value by trading simultaneously.
MH:
To minimize your tracking error, that’s very expensive, right?
EF:
Right.  You can capture some value added over the indexes just by not doing that.


Eugene Fama, Jr. Explains - Are Stocks Fairly Priced?

MH:
In light of this current market drop we have just experienced roughly half of the value of the stock prices versus a year ago, a lot of investors are wondering why should they buy at this price?
EF:
As opposed to a really high price?  (Laughter) 
MH:
Yes, as opposed to a really high price before.
EF: 
Are you supposed to buy low and sell high?
MH:
Right, is there still some rationality, an explanation of why the price is where it is, is there in fact some bad news that creates this low price and no matter what price we buy at is there some way we could have an expectation of the returns we should earn?
EF:
Well, there absolutely is.  We know that the price in general is a combination of a prediction about the future earnings of the firm and a combination about the expected return of the firms.  So basically the price of a company reflects those two things but the problem is is that historically stock markets haven’t been as good at predicting future earnings levels as they have been at predicting future average return. So in other words you know that the average return through time is going to be reflected in the discount weighing of stocks.  So that’s a really fancy way of saying that when price goes down expected return goes up, so what ends up happening is, and expected return is funny word because it sounds predictive, what that really means is that the cost of capital to the companies that issued stock is gone up and therefore investors are going to feel more risk, prices are low to induce them basically to buy securities at a riskier time and the way that that security is going to be discounted is going to actually generate a higher premium should the future recovery of growth earnings occur.  The easy way to think about it is if the stock costs 10 cents, it only has to go to 20 cents for you to make 100% return but if it costs $60.00 it has to go to $120.00 bucks.  So the stock market is going to discount securities to really imbed them with a greater potential for upset, more head room where they can actually make more return going forward.  In a risky time like this, investors are going to need to be compensated for the risk that people see.  Now eventually when that average return comes in and expected return becomes real the prices go back up and then at that point the cost of capital would certainly be lower because stocks are high in price and expected return is lower  and this sort of ends up going in a wave.  And that’s sort of the mean reversion that people always talk about and it’s really just the discount rate being followed by an average return and new discount rate and that brings this wave length pattern that we see in stock returns.  And prices on average relative to history are low, we don’t know if it is a long term phenomenon or a short term phenomenon but what do you have to hang your hat on, if it’s a long term phenomenon and economies are in real trouble and we’re headed for a great depression there’s nothing you can do anyway, what are you going to do have wheelbarrows of cash.  My choice is to believe in capital glut in the markets and the ability of markets to produce and grow and to be worth more tomorrow than today.  And so given the options and given how everything has kind of suffered I still believe that stocks certainly don’t have a lower expected return than they used to.
Let me just follow up with one other really short thing on that.  There are a lot of people out there that have to sell right now, they have margin calls and have debt to pay off and if you are not one of those people, those people who are suffering and selling at very low prices,  if you’re not one of those people and you don’t have to sell right now, I just don’t understand why you would.  It’s like you’re throwing in with people who are basically in a sad state.
MH:
This kind of reminds me of the Random Walk Theory about prices changing relative to the news and we had basically bad news and that basically results in low prices.  If there is good news you get high prices, between the two of them you end up coming up with some distribution of returns over time of which the average is your expected return.
EF:
And as we’ve seen the way that the volatility moves right now is just off the map, a couple of weeks ago was massive.  What happened in that situation is that any day that you decide to get out when the pain becomes too much, you can see the gain the next day and if you had just stuck it out a little bit longer.  You know you hate to look back and sort of see that money suddenly grow a lot and you missed that day.
MH:
Because the returns are so concentrated, maybe four or five days a year are most of the returns.

Eugene Fama, Jr. Explains Uncompensated versus Compensated Risk
MH:
There are a lot of different ways you could invest in the market, people could concentrate and try to pick the winners or they could buy the broad market as we typically recommend to investors and that brings up the academic thought of uncompensated and compensated risk, so maybe you could help discuss that concept or that idea about taking risks that are uncompensated
EF:
This idea of uncompensated risk is what a lot of people would call security specific risk and what they mean by that is when you have a portfolio that is composed of just a few stocks or a manger who hold like 40 stocks when there are thousands and thousands of stocks to choose from, the things that happen in that portfolio are going to be heavily over weighted relative to the big opportunity stocks.  Now that’s really another fancy way of saying let’s see one of those 20 stocks you have, let’s say one of them is a big position in Enron.  Enron doesn’t have to be a sympton of a larger disaster in the whole economy in fact Enron can be spiraling down when everything is very, very healthy.  So the thing that you want to do is generalize your risk as much as possible and only subject your portfolio to risks that you can’t escape because the individual decisions of any one active manager or CEO of a company and the good and back luck that happens to those individual companies are very random in nature, they don’t have a positive expected outcome like taking one stock and saying okay in general that stock, it’s individual decisions relative to the decisions all the stocks are making are so positive that I should just hold that stock because the return is higher is kind of a silly assumption because some of these managers of companies aren’t up to these important decisions.  And the real way an investor would think is get rid of all that idiosyncratic risk of those companies by eliminating them, just don’t even have that, just diversify across all the companies so the good and bad luck of any one company isn’t really affecting the value of the investment in such a strong way, it’s the greater economic help of capitalism you’re getting rewarded or punished with.
MH:
It reminds me of the fact that diversification is the only free lunch, and it’s because basically they expect the return of one stock or the index are about the same but the certainty of you getting a return from the index is much greater because you’re diversified where if you have one stock it could be a wide range of outcomes.
EF:
Right, you’re also diversifying bad management decisions and just individual bad luck.  Look at the auto companies, for instance.  If the auto companies did fail now and if your portfolio was auto companies only, does anyone really think that the auto companies going down is going to coincide with capitalism itself going down, like will all companies suffer at the same time,
MH:
Will Toyota?
EF:
And even if you think they are going to, will you still be better off?  Hoping some of them don’t and hoping them all.  So the idea that having any one industry or any one focused portfolio like that which is what’s sold over and over again to investors by brokers and by active managers and even by the media that it just doesn’t make sense from a real standpoint because it’s not making a greater philosophical statement that capitalism itself is what I want to bet on not any single capitalist.  Capitalists are individual people, they’re fallible, the capitalist system is the combined will of  the invisible hand of Adam Smith and it’s designed to generate growth and progress and eliminating the goofy decisions any one company makes that way.
MH:
That’s right. 

Eugene Fama, Jr. Explains Speculators versus Investors 
MH:
So it leads me to this idea of whether you should be a speculator or an investor, so maybe contrast the difference between a speculator and an investor.
EF:
I would say that my definition is that an investment is something where you have a positive expectation of a return.  So in other words where there is a bigger reason why the market itself is going to be worth more tomorrow than today.  Whereas a speculation to me is something like comic books.  Like you buy Action Comics #1 and pay $250,000 for it and basically hoping it’s worth $500,000 because someone happens to think it is.  It doesn’t have a reason to be worth more tomorrow than today.  Now a lot of the things that people do in the investment business are similar to that, they’re not buying comic books but they’re saying now this guy is smart running that company and this manager is smart here, I’m going to bet that they are worth more tomorrow than they are today and much more so than the rest of the economy when in fact all you’re doing is hoping that is true.  So to me the difference between investing and speculating is investors are actually taking advantage of the big ways markets reward investors, speculators are actually trying to find the ways that markets are wrong and take advantage of the ways people are wrong about their prices and hope that they’re right.  So the difference between investing and speculating is the difference between expecting and hoping, an investor has an expected return, he has a reason for the return, a speculator has the hope of a return.  I’ll even push it further, I think the other corollary for this is the difference between information and entertainment, in other words I think information is in the prices, it’s in the academic communities’ formulation of where risk comes from and that’s information.  What you hear on TV, what you see in ads, what you see on money shows, magazine covers, that’s entertainment.  Their job is to sell magazines not to create great investments.  So I think that that’s speculative as well.  So I think what you really have to do is sort of keep an ear to science,  focus on the larger economic factors that drive returns, avoid gambling and avoid falling for trendy thought that passes for information.
MH:
And when you’re speculating, there is someone else taking the other side of your bet.  You actually have two speculators competing.
EF:
Well that’s what the investment is when everyone does that.  The reality is that for a stock to trade somebody is bearish on the stock and somebody is bullish on the stock, they think the stock is going to go up, so they want to buy it, and where the twain meets is the right price for the stock.  These people on average are just as expert as each other so the prices they’re arriving at are the ones where they’re indifferent, they each think that they’re getting a good deal relative to each other.  It’s not a zero sum game.
MH:
I hear in the markets are a bunch of Harvard MBA’s trading with each other.  A lot of really smart people, for one of them to outsmart the other on a consistent basis is just not likely.
EF:
The other way to put it is no one is going to buy a stock unless they think they’re going to get a return, you’re not going to hold a stock.  The market’s job is just to set the price of all these stocks and that’s done by the bears and the bulls transacting with each other, so don’t listen to the stuff on TV that says the markets selling off right now and everybody’s negative because the market can’t sell without people on the other side of the transaction buying.
MH:
I’d like to say the stocks are priced to earn. They are put at a price so when the buyers buy them they can expect to get a return otherwise they wouldn’t show up, 10 billion shares traded around the world everyday, there’s a lot of people who think the market is going to go up at every moment, in fact you reach a bottom in their view at all times.
EF:
Yes, on the individual stock level it’s even more kind of ludicrous because people are saying a stock is expensive to trade or a really healthy stock might have a better expected return than a non healthy stock. What you have to realize is the stock prices that are low, like the stocks that are down on their luck and have really low prices, the price is reduced such that the difference between the stock that is high in price and a stock that is low in price is that investors in general are indifferent between the two.  The price of a stock is going to go down as far as it needs to go so that you’re willing to buy that stock instead of Apple or whatever stock is predicted to do really well.  So the market is very good at sort of disseminating and doing all that and we’ve never seen any evidence in active management can systematically do better and we’ve never seen any evidence either, and I’ll be so bold to say, that governments or other planned economies know how to do any better.  I think the market is the master at setting prices to distribute resources with the greatest deal of efficiency.

Eugene Fama, Jr. Explains - What is the Role of the Passive Investment Advisor?
MH: 
This brings to me a point in my mind that occurred to me in 1998 when I was thinking about starting this firm, if you can’t pick the right stocks and you can’t pick the right managers, what kind of role is there for a passive investment advisor in this industry because I don’t have a crystal ball that works and why should someone pay me.
EF:
That’s exactly why.  No one has a crystal ball so no one should be paid for having a crystal ball.  My view of it is that this is changing the very nature of brokerage, the idea of a commission based brokerage where a guy finds a great product and delivers a great investment supposedly is dead on the vine. Some of the failure of the financial sector is really showing that.  Like I think the way it is all changing is it’s not financial advice it’s about wealth management, which is really much more about educating people and coaching people and making great investors out of them.  So instead of delivering great investments per say what brokers and advisor are evolving into is something that creates great investors.
MH:
Through education, these 12 steps.
EF:
And people are determinative of returns, not in instruments.  Nobody gets their returns on paper like index returns you see in the paper, it’s always affected really strongly by decisions that you make through time whether you stick it out.
MH:
The whole behavioral science stuff.
EF:
Right.  Very, very crucial.  Today an advisor is somebody who works through an allocation based ona multi dimensional factor that is anything but passive about prices and who is very involved with what’s appropriate for that client.  And then keeping the client in the loop and involved in knowing what they’re doing, to the extent they want to be, but also just keeping them as greater investors.  It’s just a different function, they have a great function which I think it’s worth a lot more money, it’s a higher end functional.
MH:
Usually you get a better result.
EF:
Yes, exactly.
MH:
Listen Gene, thank you very much for coming by.  We’re all indebted to you for all the great lessons you’ve taught us and many other investment advisors around the world not just here in the US.
We are so pleased you could join us today at IFA.
EF:
Thank you so much, it was a lot of fun.

Special Thanks to Eugene Fama, Jr.
Vice President of Dimensional Funds Advisors