Nobel Prize

IFA’s Perspective on the 2013 Nobel Prize in Economics

Nobel Prize

We have devoted a full article to Eugene Fama, winner of the 2013 Sveriges Riksbank Prize in Economic Sciences, more commonly referred to as the 2013 Nobel Prize in Economics and we have an archive page of Eugene Fama related material. We also want to highlight this year's other two Nobel Prize winners: Robert J. Shiller of Yale University and Lars Peter Hansen of the University of Chicago. Shiller had previously garnered a lot of attention for his calls of the tech bubble at the beginning of 2000 (when he published Irrational Exuberance) and the real estate bubble in 2005. Schiller is probably best known for his introduction of the cyclically adjusted price-to-earnings Ratio (CAPE) and for showing how subsequent ten-year returns vary inversely with CAPE. Since earnings can be easily manipulated by a company’s accountants (e.g., moving expenses from the current quarter into a future quarter), using a ten-year average of earnings corrects for this phenomenon as well as the common tendency for earnings to be cyclical in nature.  One important point that is sometimes lost in the shuffle is that Shiller only said that expected returns are lower when CAPE is higher than average and vice versa. This is quite different from saying that expected returns are negative, and therefore you should bail out of equities when CAPE goes above a certain level or buy them on margin when CAPE goes below a certain level.

The idea that expected returns can (and do) vary through time is not new. As a matter of fact, one of the very first papers in which Eugene Fama1 collaborated with Ken French states, “The general message is that expected returns are lower when economic conditions are strong and higher when economic conditions are weak.” Interestingly, their analysis of the historical returns data utilized the Generalized Method of Moments2 that was developed by Lars Peter Hansen, the third winner of the prize. Hansen’s contribution is of a highly technical and abstruse nature, so it is unlikely that he ever would have become well known outside of his field had he not been declared one of the winners. The table below shows the rankings of the three Nobel Laureates on the Social Science Research Network.

Fama and Shiller have both pursued business interests related to their research. Fama has been instrumental in formulating investment policy for Dimensional Fund Advisors (DFA) since its founding in 1981 by two of his students, David Booth and Rex Sinquefield. Shiller, along with Karl Case, developed the Case-Shiller Index for tracking residential real estate prices in the U.S. Shiller is also the co-founder and chief economist of the investment management firm, MacroMarkets LLC. There is very little public information about this company. According to BusinessWeek's directory of privately held companies, "MacroMarkets LLC designs and develops financial instruments that provide investment and risk management services."

The variance of expected returns through time does not contradict the efficient market hypothesis (EMH). It simply means that investors require differing levels of compensation for the risks they bear, depending on the surrounding economic conditions. Some academics, including Shiller, rely upon a behavioral explanation, proposing that “feedback loops” of investor enthusiasm combined with rising asset prices lead to bubbles which, as we all know, do not end well. Although bubbles are apparent in hindsight, they are not always easy to spot when we are in the middle of one, and even when a bubble is declared (e.g., Alan Greenspan coining the term “irrational exuberance” in 1996), it can continue for years afterward. Concerning bubbles, when John Cassidy of The New Yorker asked Fama about the bursting of the credit bubble as a possible example of a market inefficiency, Fama replied:

“I don’t even know what that [credit bubble] means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”

When Cassidy confronted Fama with Shiller’s call of a bubble in the real estate market (the credit bubble), Fama retorted, “Shiller was saying that since 1996.” On a more serious note, Cassidy challenged Fama to defend the validity of EMH and explain how it fared in the financial crisis of 2008-2009:

“I think it did quite well in this episode. Stock prices typically decline prior to and in a state of recession. This was a particularly severe recession. Prices started to decline in advance of when people recognized that it was a recession and then continued to decline. There was nothing unusual about that. That was exactly what you would expect if markets were efficient.”

We could not agree more, and the simultaneous attacks that were leveled against Harry Markowitz’s Modern Portfolio Theory were equally misguided, as explained in this article.

In The 8-minute video below, Fama explains why periods of high volatility (such as 2008-2009) do not contradict EMH:

“The market can only know what is knowable. It cannot resolve uncertainties that are unresolvable. When there is a large amount of economic uncertainty, there is going to be a large amount of volatility, and that is exactly what you would expect in an efficient market.”

Fama correctly notes that most of the advocates of behavioral investing instruct investors to stick with low-cost index funds and not to attempt to exploit the poor behavior of other investors. The actual record of behavioral investing as a form of active management is spotty, at best. One fund for which we were able to procure data is the Undiscovered Managers Behavioral Value Fund (UBVLX) which is managed by the firm Fuller & Thaler, whose principals (Richard Thaler and Russell Fuller) are highly accomplished members of the behavioral field.  It is a domestic small cap value fund, and for the ten years ending 9/30/2013, it has performed almost identically to the DFA U.S. Targeted Value Fund (DFFVX) which is used as the basis of the IFA Small Cap Value Index. Where it gets interesting, however, is the difference in investor return, the dollar-weighted return received by all investors as a whole.

The numbers above show that the investors in UBVLX have not displayed good behavior, obtaining only half the return of the fund itself. How ironic is that! In contrast, investors in DFFVX as a group achieved a higher return than the fund itself. To top it all off, UBVLX costs a full 1% more per year in the fund expense ratio compared to DFFVX. While researching UBVLX, we discovered that it had a sister fund, the Undiscovered Managers Behavioral Growth Fund. We say "had" because this fund went out of business on 10/31/2012, according to BusinessWeek.

If you would like to learn more about IFA’s scientific and academic approach to investing, please call us at 888-643-3133.

 


1Fama, Eugene, and French, Kenneth, "Business Conditions and Expected Returns on Stocks and Bonds," Journal of Financial Economics, 25 (November 1989), 23-49.

2Hansen, Lars P., “Large Sample Properties of Generalized Method of Moments Estimators,” Econometrica, 50, 1029-1054.