Eugene Fama

Interview with Eugene Fama

Eugene Fama

Eugene F. Fama is on the Board of Directors of Dimensional Fund Advisors. He is a member of their investment committee and serves as an investment strategist. Professor Fama received his Ph.D. from the University of Chicago in 1964 and he also holds an MBA from the University of Chicago, BA from Tufts University.

Professor Fama is the Robert R. McCormick Distinguished Service Professor of Finance at the Graduate School of Business of the University of Chicago. He is the author of two books, numerous articles and he is an advisory editor of the Journal of Financial Economics. Much of Professor Fama`s research has been concerned with market efficiency and its implications for passive-versus-active portfolio management. He also laughs frequently and with little provocation.

Professor Fama is arguably the best-known financial economist in the world, but even he had to take a first step toward the winding and wonderful path of finance and economics. What was it?

"That's a good question. I was an undergraduate at Tufts and I was majoring in Romance languages. I had child already with another one coming, and inquired around to what people made in Romance languages, and I quickly switched to Economics. I got a little bit tired of studying other people's views of something that had been written several hundred years ago. So, I thought economics was a little more exciting once I got into it."

Every economist remembers his or her first experience with the stock market, a coming of age, in a way; what was Fama's?

"You won` t believe this actually. I worked for a person who had, his service was to devise ways of beating the market, based on past patterns and price series, so my job was to-- I was pretty good at statistics even then-- was to devise ways to beat the market. And I was very good at it. Every day, I came up with a new way to beat the market, but it always worked on the old data. It never worked in the new data, so then I thought, there must be something wrong with this approach (laughing), and I guess just maybe that was a dream of the efficient markets there."

Ironically, Fama started out as an active investor! Fama is frequently referred to as the Father of the Efficient Market Theory. When his paper Random Walks in Stock Market Prices was published in the early 60` s, the academic community must have been very impressed.

"Well, in the academic community, I mean, people had already been doing work like this. I think maybe I kind of codified the concept and made it a little more precise than people had talked about it until then, and I stayed at it longer."

It paid off, since Fama says other people got bored with it and went on to other things, missing a strong opportunity.

"Among academics at that time, there was a lot of interest in coming up with tests of how markets worked. This, it' s kind of serendipity, this was the time when the first reasonably sized computers were around and the stock market data was fairly easy to collect, so the natural thing was to apply the new computers to us, to see how markets worked. As I said, I had already had some experience with this as an undergraduate, so it was a natural thing for me to pursue. But it wasn' t something I had just dreamed of. There was a lot of interest in it already at Chicago and there were a lot of people coming to Chicago from other places visiting, talking about how one would go about doing this kind of thing."

Fama's Random Walk Theory may have been embraced by the academic community, but since it threatened money managers directly, how did the investment industry react?

(Fama all but dissolves into laughter at the question.)

"To this day, they haven' t been all that receptive; I remember I used to get outraged when I was (young). I would get quoted in newspaper columns and they'd get it all wrong. And they had no kind of idea really what it was all about, and Tim Rorey said to me, don't worry about what they say. But, you know, at that point and time, there was no such thing as passive management. There was no such thing. Everybody thought you could beat the market."

Beating the market is not the most vital consideration when investing. What about the efficient market theory? What is it and why is it important to investors?

(Fama calls it a very simple concept.)

"It says that prices reflect all available information, so you're always paying a fair price. That's an important concept for investors because it says they're always paying fair prices, their task is simplified. They basically just have to decide what kind of risk return trade-off they want to be involved in and how much risk they want to take in order to get more or less expected return. But they don't have to worry about picking the stocks because they can operate under the presumption that the stocks will be fairly priced."

This works outside the beliefs of beating the market. Creating a theory for the benefit of academics is valuable, but it must be assumed that regular investors could also profit from hearing the efficient market theory.

"I suppose, you know, in this day and age we've educated so many MBA students it would be hard to believe that any professional investor hasn't heard of that concept. Now, the stranger& I don't know. I guess people walk by me all the time, they're recognizing me, so I guess that they heard of it and brought it out. Or they haven't heard of it."

(More laughter.)

When market prices change dramatically over a relatively short period of time, investment professionals like to say that such price movements are proof that markets are not efficient. How does the Father of the Efficient Market Theory respond to that?

"I don't think you can ever say much about a particular price change, but the 1987 crash is the one that lots of people point to. My response to it, some people think it's facetious, but I don't think it really is. We've had two big crashes in this century. One was an under-reaction to subsequent economic events in 1929. The last one turned out to be a mistake. So one out of two, it's about exactly what you'd expect from an efficient market. But, I don't know how deeply you want me to go into this."

Warmed up now, Professor Fama needs little encouragement to expound on a subject he is master over.

"This is a common notion: That there's too much noise in prices, and these big price changes are an indication that there's too much noise." Noise refers to investments that were not chosen using empirical evidence, but rather market timing, stock picking, and track record investing. Eventual word of mouth can result in a huge inrush or a mass exodus of this noise. "Well, statistically that has a straightforward implication. What it says is that the volatility of prices should go up more slowly than the horizon that you're looking at (noise supposedly interferes). But in fact when you look at the series, the volatility does go up more or less exactly as you would expect if there were no noise in the series. So, that's why I say you can't look at individual price changes. It's the arrogance of people to think that if I can't explain the individual price change, the market has to be inefficient. Why should you be able to explain it? Who knows what went into that price? What you want to know in the long term is the volatility erased, so that long-term returns are much less volatile and would be predicted based on the volatility of short-term returns. And that doesn't turn out to be true. Long-term returns are about as volatile as you would predict based on short-term returns and based on the proposition that there is no noise in the series."

(The Professor said a mouthful!)

More and more of the investing public are realizing that the markets are not predictable, and they are turning to index funds. It is possible to assume that the efficient market theory is being embraced by a large segment of the investing public.

(Fama could not begin to guess how large a segment, but he does credit certain companies with bridging the gap between the theory and the public.)

"Certainly, you know, DFA is an example really of the investing public embracing it. Vanguard's another example, American National. Wells Fargo has played both sides of the game, I think."

Of all the money that is under management, Fama estimates that about 40 percent or more of it is passively managed. "It's just the people are paying active manager fees for passive managers. Passive management, if you take a big pension fund that has many different managers and they're all being paid to produce active management, when you look at the overall portfolio, it might very much look like the markets, so they say, what you would decide to do, is to pay one percent to buy the market."

(The Professor is laughing again.)

"And there is quite subtle logic in doing that, but there's much more effective indexing than you can see by looking at how money under management is allocated across active versus passive management."

Although pleased with the progress of passive management, Fama admits, laughing, that he wishes its impact were even greater.

Eugene Fama is famous for his three-factor model, but has often been criticized that his own research shows markets are not efficient. In essence, he is charged with contradicting himself.

"There are people who think, not that the three-factor model is an indication of a market in efficiency, but of the relation between book to market equity and average returns. That's a manifestation of a market in efficiency. Where our three-factor model quarrels with that is we say, no, that's not the case. This is a real risk that you can't diversify and that`s what you're getting compensated for. So there is still an on-going debate in literature about how you interpret this effect. People's quarrel is that we haven't identified what fundamental things of concern would lead to the book to market effect. We talked about distress because our book to market is associated with distress, but the way Ken talks about it, and I think he is right, you're looking at something overpriced. What you're doing in looking at something overpriced is, you're looking at the information and the price about expected returns. So when prices are lower relative to fundamentals, that means expected returns are high. And in every asset-pricing model, that's a manifestation of some sort of risk. Everything we've done says it doesn't go away."

The study of behavioral finance seems to be in vogue these days, it is attracting a lot of attention. Is there any merit to that argument?

"Well, my good friend, Dick Thaylor is kind of the guru of behavioral finance and every time he walks down the corridor, I ask him a question. The question isn't a complete question, but a person on the street wouldn't know what was going on. My question is always the same: Now what is it? He knows what it refers to. It's behavioral finance, and the reality is they haven't defined the top. They haven't defined the area. What it is at this point is unkindly speakings, just dredging for anomalous looking things in the data. But the fact is that even in a perfectly efficient market, every data set would be on the foremost phenomenon just on a strictly random basis. So that's not evidence for or against anything. If you don't have a specific view of what behavioral finance is in the way it manifests itself in the behavior of prices and returns, you don't really have anything to work with because everything you observe really can be rationalized in the context of an efficient market. For example, all of these studies on behavioral finance basically look at how prices react to different kinds of announcements. So sometimes, it seems to be the case that prices under react, sometimes it seems to be the case that prices overreact, but that's exactly what you predict in an efficient market. You're going to see drift one way or the other, but it will be random. So if you don't have a theory that predicts when it's going to under react and when it's going to overreact, you don't have anything. It looks to me like an efficient market, just a random price behavior. "

Professor Fama has a paper coming out soon on the subject, Market Efficiency Long Term Returns on Behavioral Finance. Since 1982, the stock markets measured by the S&P 500 have had a phenomenal run.

(Fama agrees that there will be a big negative return, but cannot venture an opinion as to when.)

"My expected value always is the historical return, but there are always down turns. There are always up turns."

(Asked if he considered this a correction, however, he shakes his head.)

"A correction? No, that's a bad word. Correction is only something you can talk about with hindsight. An efficient market person never talks about a correction. It may turn out to be a correction, but it wasn't something you would have predicted in advance as a correction. How many people since 1982 have been saying that the market is too high year after year after year? I'm glad I stayed in. That's the benefit of being an efficient market person in all this time (laughing). I never got out. There's so much mispricing out there. How is it that all of these, all the smart money can't seem to find it. When it's entirely simple, it's not there. The prices are right, but there is no evidence that active managers add value. I'll go back to Warren Buffett because maybe he can do it, ok. But how does he do it? He doesn't claim he can pick a thousand stocks or a hundred stocks. He claims he can pick one every couple of years. But even he who has taken to be the prime example of the successful active manager doesn't claim he can do it in general. He just claims he can do it in very few particular cases."

Fama is still laughing. It is laughable: a successful stock every couple of years. Individual investors seem to act on emotion. They sell when things are bad, they go buy high when things are good. It seems that investors are an inefficient bunch, yet we're trying to say that it's an efficient market. The professor agrees.

"Well, it's certainly irrational behavior in every market, but the issue is, what will be the effect of that behavior on prices? From my study over the past data, it says those people aren't the people who make the prices. The people behaving irrationally would be people introducing lots of noise into the prices, so we go back to where we almost where started. What you would expect to see is much less volatility in the long term that what we predicted by projecting the short term. But you just don't see that. So, this irrational behavior somehow must be washed out by rational behavior on the part of other investors. Now, nobody really understands the process by which the markets work. Nobody understands the nuts and bolts of it down to that particular micro-economic level. So far, we haven't seen much evidence that it has any noticeable effect on price formations. Why that is the case? Well, that says I know more about price relations than I do. I really don't know why."

In the July 6, 1998 issue of Fortune Magazine, an extensive profiling of dimensional fund advisors included this on Professor Fama: On visits to DFA's California Headquarters, he wears a special beeper that goes off when the wind is right for windsurfing. Once alerted, the 59-year-old Fama packs up his sailboard and heads for the beach, or, if he's stuck in a meeting, he exhorts the participants to hurry up. Fama is laughing again; he is the Windsurfing Father of the Efficient Market Theory. "I do when in California, sure. Only, I don't say let`s get this meeting over with, I say the meeting is over." Of course, nobody ever argues.

June 1, 1999