Rational Reminder Podcast: Eugene Fama on Efficient Markets
During the 200th episode of the Rational Reminder podcast, Nobel laureate Eugene Fama joined hosts Benjamin Felix and Cameron Passmore to discuss various industry topics. Below are some highlights, which have been edited for clarity. Listen to the full episode here.
Fama on Market Efficiency [0:04:49]
When we say a market is efficient, that means prices reflect all available information.
If markets are efficient, investors can’t expect that stock-picking is going to generate superior returns. You get the risk-adjusted return appropriate to the risk level that you take with your portfolio, but you can’t expect more.
With actively managed portfolios, the distribution of returns is around zero before fees and expenses. After fees and expenses, it’s a big negative sum gain for those who go into active management. The distribution of outcomes looks a lot like what you’d expect by chance if there were no ability to pick investments that have above-normal, risk-adjusted returns.
You can’t have 100% of the market in passive funds because then there is nobody to trade to make the market efficient. You want the people who have information (that other people don’t have) to stay in the market and use that information. The real question is, how many of those people are there? How many does it take to make the market efficient?
Most of the trading by these investors just offsets the foolish things other active managers do. Active management doesn’t always make the market more efficient. Sometimes it makes it less efficient because people make bad bets. The informed participants have to offset these uninformed participants who are making the bad bets. The more uninformed participants there are, the more informed participants are needed to offset them.
Fama on Factors [0:11:43]
[Dartmouth Professor] Ken French and I chose the size and value factors to complete the three-factor asset pricing model because, at the time, they were the two biggest anomalies for the capital asset pricing model (CAPM). The CAPM could not explain small [cap] stock returns or the difference between value and growth stock returns.
For the five-factor model, we added profitability because of normal valuation theory, which says if you hold constant all other variables, then you should observe a positive relation between profitability and expected returns. We also put in an investment factor. When you consider all these things together, you should see that average returns vary positively with profitability and negatively with investment.
Fama on the Fed and Inflation [0:33:31]
Ever since the [2008] financial crisis, inflation has been all over the place and interest rates have stayed near zero, so short-term bonds haven’t been a good hedge against expected inflation. Now, we’re going into a very interesting period where we seem to be up against some serious inflation.
The Fed prioritized going into the quantitative easing (QE) business over controlling inflation because, at the time, inflation was very low. Now, they are faced with inflation and their only tool is to raise the short-term interest rate. But the Fed’s influence is very limited.
If they raise the federal funds rate, how far do they have to raise it to have any effect on inflation? That’s a wide-open question. We don’t have any data at all on that because this QE business is new. The Fed always operated in an environment where there were no free reserves. Now, you have about $9 trillion worth of free reserves out there. We’ve never had this, so we don’t know what it will take in terms of raising this short-term rate to control inflation.
Fama on the Impact of Artificial Intelligence on the Industry [0:50:41]
I came online when computers were first coming around. In principle, we have a lot more information now, or we get the same information a lot faster, than we used to. Plus, we have ways of distributing it that were unknown 50 years ago. But you can’t see the tracks of that in the behavior of prices. You can’t see that it has had any noticeable effect on whether the market is more or less efficient. We just don’t know.
My view is that we don’t know because the market has always looked pretty efficient. It’s nice to have all this information and to get it so quickly, but it doesn’t seem to have improved markets that much.
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