Unapologetic after All These Years: Eugene Fama Defends Investor Rationality and Market Efficiency
Addressing the 65th CFA Institute Annual Conference in Chicago last week, Professor Eugene F. Fama of the University of Chicago Booth School of Business recounted a lifetime of distinguished scholarship and achievement. The unofficial “father of modern finance” took on recent criticisms of the efficient markets hypothesis (EMH) and issued stinging rebukes of “too big to fail” banks, underfunded pension plans, active investment management, and behavioral investors.
With regard to the financial crisis, Fama said, “I take a particularly contrary view on it. I don’t think it was a financial disaster that caused an economic disaster. I think you can’t reject the hypothesis that it was an economic disaster that caused the financial disaster.”
Fama also challenged the notion that the expansion of sub-prime lending itself was primarily to blame. “I think lots of crazy things were done” during the run-up to the crisis, he said. “There was probably political pressure on people financing and granting mortgages and things like that. It’s hard to think that if there wasn’t a pretty significant recession that the financial system would come crashing down.”
For Fama, the most unfortunate consequence of the crisis was moral hazard. He argued that more banks should have been allowed to fail. “The worst thing to come out of that experience in my view is ‘too-big-to-fail,’” he said. “The institutions that are too-big-to-fail have their debt priced as if it was riskless, which gives them a low cost of capital, and creates an environment where it is easy for them to expand. Then we have an even bigger problem.”
Fama said he was unimpressed with new regulations that emerged from the crisis. “Basically you need to push up the capital adequacy ratio high enough so that debt is in fact riskless, because the capital adequacy ratio is so high there is guaranteed recovery.” He added: “I think 25% is reasonable, and if that doesn’t work maybe go higher.”
Banks were not the only target of Fama’s ire. Sponsors of defined benefit pension plans “didn’t put enough money into these plans,” he said. “The reality is that what they say the liabilities are is about a third below what the liabilities actually are. They just discounted a stream of liabilities by the expected return on the assets.”
Since liabilities are essentially inflation-indexed claims on the sponsor, Fama believes that the appropriate rate to discount them would be something like 3%, not the current 7–8%. “They are betting that the market return will bail them out, but during the life of the plan there will be multiple bad markets,” said Fama. “State and local pension plans are basically giant hedge funds.”
Turning to active investment management, which Fama argued is a zero-sum game after costs, he pointed to his own work with Kenneth French, which shows evidence of both inferior and superior performance in the extreme tails of the cross-section of all mutual funds over the study’s time period. “If you put the costs back again only the top 3% of managers produce returns that indicate they have sufficient skill to cover their costs.” Taking three or four thousand funds, Fama said, “you expect the top 3% to look good — that is the luck versus skill part of it — which means that the other 97% look worse.” He cautioned against data mining and said he was particularly skeptical about fund studies that used only a short time period: “Five or ten years is garbage, it’s basically noise. 35 years is what you need to conclude that the equity premium is undeniably positive.”
Fama also issued a measured critique of behavioral finance, which he regards as just story-telling but “very good at individual behavior.” Although conceding that some sorts of professionals are inclined toward the same sort of biases as others, he asserted that “jumps that [behaviorists] make from there to markets aren’t validated by the data. If it is irrational it should go away.” Highlighting inconsistencies in behavioral explanations, Fama said, “They have stories that can explain momentum and they have stories that can explain reversal. That is too flexible. That is not a science.” Daniel Kahneman’s vision of a two speed brain, one for long-term rationality and the other for speedy assessment of possibilities, is wholly rejected by Fama, who argued the case for ever-present investor rationality by asserting that the two speeds are just like the two sides of the brain. “What would they cause you to say? Except that yes, some people behave rationally, or no, some people behave irrationally,” Fama said. “My story is that they do both.”
Delegates were also treated to discursions on the equity risk premium (ERP), the subject of a recent CFA Institute Research Foundation monograph, and the chronology of finance theory. According to Fama, “Macroeconomists have a problem with the observed ERP because in their models the ERP should be around 0.5% when in fact it is 5-7%. Two things could be going on here: Either expected profitability is very high or the discount rate, the expected return on stocks is going down.” Since Fama has found no evidence of rising profitability expectations, he surmises that the discount rate must have fallen and the expected return on stocks required by investors is lower. His own preference is for an ERP estimate of around 4%. “Market efficiency does not imply that the risk premium is constant,” he concluded.
Finally Fama clarified his own journey from staunch supporter of the capital asset pricing model (CAPM), which he still views as intuitively attractive, to his development of the famous three-factor model with Kenneth French. This paper became one of the most cited in finance by identifying several sources of variance, or risk factors, which are associated with things that cannot be diversified away. Fama continued his theoretical discourse by contemplating the problems with momentum, a third research interest sitting alongside value and size risk factors. “The problem with momentum is that if this represents time variation in the risks of stocks then it is really discouraging because the turnover in these stocks is so high,” said Fama. “What is a momentum stock today probably isn’t one three months from now. Of all the things that I think are potential embarrassments to market efficiency that is the primary one. It’s just a model,” he said.