Eugene Fama

Fama’s Win: Made Sweeter Through Time

Eugene Fama

“Complicated regulation may be a nice idea in principle, but in practice it never works, because eventually with regulations very complicated, the regulators get captured by the regulated.”

--Eugene F. Fama, 2013 Nobel Prize Winner in Economics, Quote taken from a 2010 CNBC interview challenging Fama’s research on Market Efficiency

 

Eugene Fama’s tireless and significant contributions to inform investors about the source of stock market returns had long-convinced all of us at IFA that Fama was an obvious choice for the Nobel Prize in Economics. In fact, from the moment I launched IFA back in 1999, I was certain it was only a matter of time that Fama’s works would win him the coveted distinction. Each year, I was disappointed and even stunned when the committee did not award him the Prize.

Fama’s discovery of Market Efficiency earned him the moniker “Father of Modern Finance” and led to the creation and mass proliferation of index funds and ETFs — a movement that reshaped the expected outcomes for those who simply bought the market as opposed to trying to beat it. His isolation of the risk factor exposures that carry risk premiums additional to the market premium, and his continued work in isolating the sources of returns have literally cracked the code of investing science. A feat Fama humbly says, “Is just arithmetic.”

If you are lucky enough to spend time listening to Eugene Fama discuss his research — as I have been fortunate to do -- you would quickly be captured by two impressions. 1) You would become instantly aware that this man is “the real deal” – a true giant in the world of finance — possessed with so much drive and passion for his work that he is giddy to share his findings. 2) He is a true scientist — challenge him — he is less driven by his ego than he is by the quest for the truth as it can only be revealed through testing — again and again.

I was so disappointed, year after year, when I was certain Fama would win the Nobel Prize – and he didn’t. And yet, it was so worth the wait. Here’s why: In 2008-2009, the world’s markets suffered a devastating slide. Too big to fail had many convinced the game was rigged and that Fama’s Efficient Market Hypothesis was a farce. The market could be played, and investors had been played.

During that downturn, Fama’s work was challenged as it had never been challenged before. For example, in this CNBC interview (see below), Fama displays his masterful, purposeful pursuit of the truth, his rationale, and his affirmation of the markets as the ultimate arbiter — classic Fama — pure genius. His Efficient Market Hypothesis held up through the most challenging market since the Great Depression. And, after that true litmus test of his research — it was then he was awarded the Prize — made sweeter through the waiting and the proof in the pudding. Five years after the fall, Fama wins the Nobel Prize as market efficiency prevails, and the U.S. market  has staged an enormous comeback with a fresh high for the S&P 500[1]. Congratulations Professor Fama! 



[1] Publication date 10/22/2013, S&P500 closed at 1,754.67

 

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Testing Market Efficiency – An interview with Eugene Francis Fama, Father of Modern Finance

Eugene F. Fama was interviewed on CNBC's "Squawk Box" in 2010 about the financial crisis and financial regulatory reform. Today he's a winner of the Nobel Prize in Economics. Let's take a look back at what he said about market efficiency then.

Q. Are you ever surprised that certain things in the past we thought were settled are apparently not settled...I guess I am referencing the notion that maybe capitalism is at fault for a lot of our problems and the notion that even the Efficient Market Hypothesis (EMH) doesn’t work.

A: What do you mean by that?

Q. I guess we’re questioning whether capitalism is the answer to our needs versus regulation and more government.

A. Let me first explain what efficient markets is all about. The concept is very simple. It says prices reflect all available information, so that it’s difficult – if not impossible – to beat the market.

Now efficient markets and capitalism are very closely interrelated, because one of the founding principles of capitalism is that prices provide good signals for the allocation of resources—and that’s basically the principle of efficient markets.

Now, one of my colleagues always says capitalism is an awful system; it’s just better than everything else. I still think capitalism is the way to go. Government interference and regulation are not a good way to go, because a government’s incentives are political. It can’t fail, so it really isn’t subject to discipline that would foster growth of the economy and the well-being of the population as a whole.

Q. I guess my point is you never know whether you have a pure capitalist system because of small things that government can do on the margins, and you never really know whether you have a pure market either to test whether it’s truly efficient. For example, was the market efficient the way housing prices were valued? You look at the stock market. Was the NASDAQ more efficient when it was at 5,000 or when it was at 1,000 within 12 months of each other? You know when you make a semi-conductor, a speck of dust in a clean room can throw off the whole process, so a very minor...you know it’s something that gets into either the capitalist system or the free market system…you don’t know whether to fault the theory, or whether there’s something that corrupted it.

A. Well, everything you just said basically implies that it should be very easy to beat prices. There should be lots of evidence that people can time markets and do much better than simply buying and holding the market. In fact, there is no such evidence. There is no evidence that people are good at market timing, even the professionals who attempt to do it. So when you turn around and actually test market efficiency for all practical purposes, it works very well.

Q. Gene, you know the past crisis was one where people inferred from that and from some of the problems that we had that markets don’t work. That’s a commonly said proposition after the financial crisis. I guess another view, and I may be someone who subscribes to this view (and I’d like to hear  your comments on it), is that markets certainly aren’t perfect in terms of predicting what happens before the fact—but actually markets are very good—in the sense they are ruthless punishers of those who deviate. So if we look at the crisis and say, “what happened?,” you can find plenty of examples of individuals having deviated and the markets going after them in a brutal fashion. So would you view the recent evidence as positive or negative evidence for the efficiency of markets?

A. I think it’s quite positive. Historically what’s happened is that markets move in advance of economic activity—basically how well the economy is doing—so in good times markets tend to move up. In advance of the good times—and they tend to move down when times are turning bad—and even to predict the downturn to some extent, but they can’t predict what’s basically unpredictable. They can only deal with what they have at the moment. So people tend to do what I call “condemning markets” based on 20/20 hindsight. So after the fact things turn bad, prices go down a lot—lots of that was unpredictable, so you can’t really blame markets for that. But let’s look at the experience that we went through: all markets went up during a sustained period of good times—commodities markets, stock markets, bond markets, real estate markets—and all went down in advance of the most severe recession we’ve had since the 1930s. This is exactly what you would expect them to do. There’s nothing inconsistent with market efficiency based on those observations alone. People are using the word “bubble” as a common everyday expression now, but bubbles basically imply movements in prices that are predictable—and there is no evidence that the end of these things are ever predictable.

Q. Given the unpredictability that you’re talking about, do you think there’s much hope for the effects of financial regulatory reform on actually stemming these crises from occurring in the future?

A. The big gorilla in the room at this point is the whole concept of ‘too big to fail.’ That’s perverting activities and incentives in financial markets all over the place. Basically, you’re giving the big financial firms a license to increase risk where the taxpayers will bear the downside and firms will bear the upside. That is not capitalism. Capitalism says that if you perform poorly, you fail. We basically have to take ‘too big to fail’ off the table. This bill—1500 pages or whatever-—I think wants to do that, but the problem is it’s way too complicated. Complicated regulation may be a nice idea in principle, but in practice it never works, because eventually with regulations very complicated, the regulators get captured by the regulated. We’re seeing that being claimed at this moment with respect to the regulation of the oil and gas industry. But it’s not unusual. It happens all the time—that the regulators get captured by the regulated. We need a reform that takes ‘too big to fail’ off the table and is self enforcing. Now just letting people fail is one such reform. I would have been for that all along, but we know neither political party will do that. What we know is—and you were part of the process, so you know better than I do—what we know is that governments will step in and bail when times go bad. So the only solution and it’s not a simple solution…there is a lot of complication in the details…the only solution that I see is  to raise the capital requirements of these firms dramatically. I am not saying raise equity requirements from 3% to 5%. Maybe they have to go up to 40% or 50% so that this whole idea of these big firms failing is just taken right off the table. Let the stock holders bear the up and the down without having to pass it on to the taxpayers.