By Beverly Goodman, September 20, 2014, Barrons
What Nobelist Eugene Fama really thinks about the enhanced investing craze.
Smart beta, the term everybody loves to hate, was one of the most prominent topics at the Morningstar ETF conference last week. But the highlight of the three-day event was the talk given by the grandfather of the concept, Nobel Prize winner Eugene Fama.
A professor at the University of Chicago's Booth School of Business, Fama is best known for his development of the efficient market hypothesis, which states that stock prices inherently reflect all the available, relevant information. His decades of seminal work with Dartmouth professor Ken French includes the "three-factor" model, which posited that certain factors, or qualities, tend to outperform, including small-company and value stocks. That work formed the basis for Dimensional Fund Advisors, a $378 billion asset manager based in Austin, Texas.
It's also essentially the basis for the fastest-growing segment of the exchange-traded fund market -- factor investing, fundamental indexing, strategic beta, call it what you will -- the tweaking or reinventing of indexes in order to beat the market without active stock-picking. "His work has transformed the way finance is viewed and conducted," Ben Johnson, Morningstar's head of ETF research said in the introduction to his Q&A with Fama. "I don't think we'd have a room of 700 people here talking about ETFs and passive investing without the work Gene has done over the years."
SO WHAT DOES FAMA make of the current trend to fashion new indexes in an effort to beat the market? Some excerpts from his talk:
On how the concept of market efficiency has evolved: "It's such a simple concept, there hasn't been much evolution."
On whether an increase in index funds and ETFs could make the market less efficient: "There's this fallacy that you need active managers to make the market efficient. That's true to some extent, but you need informed active managers to make it more efficient. Bad active managers make it less efficient."
On when active management makes sense: "When is it good? The answer is never. That's a really difficult perspective to get people to accept."
On why people keep investing with active managers: "Why? I don't know. The individual is clearly so much better off [in index products] it's laughable."
On how many actively managed mutual funds beat their benchmark: "Before costs, about 50% beat the index. But that's exactly what you'd expect by chance. You can't tell luck from skill."
On enhanced index investing, also known as smart beta: "One of my research assistants was trying to enumerate the possible number of factors. I think he quit at about 150. Once you get beyond two factors, the third adds very little -- no matter where you start. Factors tend to be correlated; value stocks are negative momentum stocks. So if you want momentum as a factor, you have to give up some value."
On behavioral economics: "Economics is all about behavior. The issue is whether that behavior is rational or irrational. Some behavioral economists study people; others dredge for anomalies."
On how he invests: "I have a capitalization-weighted portfolio of all traded stocks. I don't fool around with bonds. I'm a tenured professor; the university issued me a bond."
An investment in Exchange Traded Funds (ETF), structured as a mutual fund or unit investment trust, involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks such as not diversified, price volatility, competitive industry pressure, international political and economic developments, possible trading halts, and index tracking errors. No strategy assures success or protects against loss. Stock investing involves risk including loss of principal. Please consult a financial professional prior to making any investment decisions.
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