Eugene Fama's Nobel Prize Lecture

Monday, December 9, 2013 10,392 views

This past Sunday (December 8th), Eugene Fama (along with Robert Shiller and Lars Peter Hansen) delivered his Nobel Prize lecture titled “Two Pillars of Asset Pricing.” This lecture should not to be confused with his acceptance speech which will occur on December 10th. As we expected, the two pillars are market efficiency and the three-factor asset pricing model, but as Fama remarked, they really should be called the “Siamese twins” of asset pricing. Fama was referring to the joint hypothesis problem in which any statistical test of market efficiency is simultaneously a test of the asset pricing model that is used to measure efficiency and vice versa, meaning that neither market efficiency nor a given asset pricing model can be definitively established (or rejected) via statistical testing.

A few pundits have criticized Fama for his steadfast refusal to address bubbles, which they view as a contradiction to market efficiency. Perhaps Fama was addressing them when he said the following about the “nefarious” bubbles:

“People who use the term ‘bubble’ never tell you what they mean. [They] seem to define a bubble as a strong price increase that implies a predictable strong decline, but the available research provides no reliable evidence that price declines are predictable. Thus, at least as the literature now stands, confidence statements about bubbles and what should be done about them are based on beliefs, not statistically reliable evidence.”

In response to Fama, when Shiller delivered his lecture, he opened with his definition of a bubble as “a speculative fad” and then described the feedback loop in which a strong price increase is followed by positive media coverage leading to new buyers and further price increases. Clearly, this definition would not be satisfactory to Fama because it does not offer a precise method for determining when we are in the midst of a bubble. Fama views the whole concept of a bubble as somewhat questionable because it proposes that there are prices at which expected returns are negative, implying an absurd situation of buyers who are completely irrational. Here is how Fama spelled it out:

“Stock returns are somewhat predictable from dividend yields and interest rates, but to my knowledge there is no statistically reliable evidence that expected stock returns are sometimes negative.”

As someone who has been studying and contributing to this field for over half a century, Fama’s credibility on this topic should be viewed as unassailable. This, of course, hasn’t stopped the advocates of active management from attacking Fama and criticizing the Nobel Committee’s decision to award him the prize. Here is what Fama had to say about them while he was explaining the 3-factor model:

“This little ‘a’ here—that’s the alpha of this model—the unexplained return that in principle an active manager would add to the predictions of the model. Now it turns out they don’t do that very well.”

Unfortunately, Fama did not have the time to go into his own research (along with his long-time collaborator, Ken French) showing just how dismal the results of active management have been. One of our favorite papers of theirs is “Luck vs. Skill in the Cross Section of Mutual Fund Returns”1 in which they found that the total amount of true alpha among all the active mutual fund managers is indistinguishably different from the amount that would exist if they were all simply choosing stocks randomly.  Of those few who did have true alpha, there was no reliable way to identify them in advance of their alpha. The pie chart below summarizes their findings:

At the end of his speech, Fama took one last dig at his detractors when he remarked, “It’s good to stop here actually because the rest of it I would have talked about behavioral finance, and you really don’t have to talk about that very long.” For the record, we at IFA embrace the findings of behavioral finance and consider it especially useful in helping investors understand their natural tendencies to make sub-optimal decisions. As far as the challenge it presents to market efficiency, we do not view it as something that presents an opportunity for investors to beat the market. To once again put it in the words of Eugene Fama2, “For investment purposes, there are very few investors that shouldn’t behave as if markets are totally efficient.”

1Fama, Eugene F., and Kenneth R. French. 2010. “Luck Versus Skill in the Cross-Section of Mutual Fund Returns.” The Journal of Finance, vol. 55, no 5 (October):1915-1947.

2Rolfes, Rebecca. “A Father of Modern Finance.” Chicago Booth Magazine, Fall, 2013.

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