Eugene Fama is the
Robert R. McCormick Distinguished Service Professor of Finance at the
University of Chicago Graduate School of Business. He coined the term
“efficient market,” which gained widespread use following the
publication of his paper on efficient capital markets in The Journal
of Finance back in 1970. His recent work has essentially redefined
our understanding of which type of stocks pay the greatest returns.
Professor Fama joined us on The Investing Revolution radio
program on
April 13 to discuss his groundbreaking work.
Professor Fama,
what exactly did you mean when you coined the term efficient capital
markets back in 1969?
If you interpret the term strictly, what it means is that everything
knowable about the future is already built into prices, so there’s not
much you can do to beat the information in the current price. And as a
consequence, what you can expect from investing is just normal relation
between expected return and risk. I never took that strict definition
that seriously. Nothing’s ever perfectly efficient. That’s just kind of
the extreme by which you judge things. My practical definition would be
that most people can’t come up with information that isn’t already in
the price, so as far as they are concerned, the market is efficient.
It’s very difficult to find people for whom that’s not true.
How would you
define an asset class?
Well, you can begin with bonds vs. stocks. Then within the stock
category, the research of the last 20 years that Ken French and I have
been doing says that basically there are two kinds, two divisions of
stocks that are interesting and seem to be related to average return.
One is small stocks vs. big stocks, where small stocks seem to generate
higher average return than big stocks. The other is between value stocks
and growth stocks. Growth stocks are stocks of companies that are
profitable, fast growing, they look really good, they’re strong
companies typically, especially the big ones. Value stocks tend to be
the other end of the spectrum. They’re not so profitable; they’re not
growing that rapidly. A simple way to think about it is that growth
stocks have very high prices relative to fundamentals like earnings or
book value because they’re expected to grow a lot in the future, whereas
ratios of prices to fundamentals are lower for value stocks because
they’re not expected to grow, actually might be restructuring, and so
declining in size for a while.
Along with Ken
French, you wrote several articles in the early 90s on the size effect
and the value effect. How has that research evolved since you wrote
those papers?
We’ve been trying to do is fill in the details. One of the things we did
was to test in detail whether the same phenomena showed up if you looked
at different time periods other than the one we studied initially. We
started in 1964 in the initial study, we extended it back to 1926 and
then we looked at foreign markets to see if we observed the same thing.
It seems to show up around the world pretty much in the same way and in
different time periods. In our view, this is all reward for risk. Value
stocks are basically riskier, they have higher cost of capital than
growth stocks, and small stocks are basically riskier and have higher
cost of capital than big stocks. And that’s what you’re getting. But
risk is risk and in the law you can’t expect these things to pay off on
a year-by-year basis and there are long periods of time when they don’t
pay off. That’s just the essential nature of risk and return. If you
want to see these things on a reliable basis, basically you’re talking
about investment lifetimes, 35-year periods.
There’s also a
debate that’s been going on since you introduced the concept of
efficient markets, between behavioral theorists and efficient market
theorists. Where does the debate stand in your view and why does the
other side have it wrong?
Take the
value/growth stuff. In our theory, that’s just risk and return. The
value stocks, these are relatively distressed companies, they have
higher cost of capital, which means they’re going to have higher
expected stock returns. In their view, the spread in returns between
growth and value stocks comes about because both are mispriced. The
prices of growth stocks are too high and the prices of value stocks are
too low. In their view, what happens is these price imbalances get
corrected and as a consequence, the value stocks end up with higher
returns than the stronger growth stocks. So they don’t disagree on the
outcome, they disagree on the source. In their view of the world, people
never learn. There’s always market overreaction to past performance and
the next generation of investors is as bad as the last. There’s never
any learning in the investment process. To an economist, that doesn’t
ring that true. We don’t expect people to be forever fooled.
You wrote a
commentary last year in The Wall Street Journal with Ken French
that talked about the way mutual funds are taxed relative to ETFs. Can
you tell us what the problem is there and how it can be corrected?
The
mutual fund problem is that investors who come in now, if you buy a
mutual fund now, you’re on the hook for the fact that they may have
unrealized gains in their portfolio. Most typically do. And when those
gains are realized, you may be hit with a capital gains tax even though
you didn’t personally get those gains. So in other words, when you buy
individual stocks, you get taxed on the capital gains that you have from
the time that you buy the stock to the time you sell it. But for mutual
funds, the taxation doesn’t go that way, at least in the U.S. In other
countries it does. In mutual funds, you’re liable for the taxes on
unrealized capital gains when they are eventually realized. This isn’t
such a problem for passive funds, by the way, but it’s a pretty big
problem for active funds. [Our] argument was that basically mutual funds
should be taxed in the same way as people get taxed by individual
stocks. In other words, you would just pay capital gains based on the
price that you paid for the fund and the price you eventually sell it,
which makes a lot of sense. Who knows; tax complications seem to be a
favorite of the federal government.
What are the
one or two most important aspects or points you would want individual
investors to learn from your work and remember as they invest throughout
the rest of their lives?
I think what they
should remember is they’re probably not informed about much of anything.
I don’t think I’m informed enough to say that markets aren’t efficient
as far as I’m concerned. I’ve been studying markets for 45 years now and
I don’t think I can forecast which stocks are going to beat other
stocks, except based on the fact that some stocks are riskier than
others. So they should focus on asset allocation, how much risk they
want to take for potentially higher or lower reward, and then they
should stick to whatever plan they choose. Don’t do a lot of switching
around. And diversification is your buddy. Always hold a diversified
portfolio.
