Professor Eugene Fama’s Nobel Prize is richly deserved
Our investment philosophy is based on the findings of world’s leading academic financial economists. It encapsulates what is now a vast body of research in the area known as modern portfolio theory, that has its roots in a 1952 paper by Professor Harry M Markowitz, called “Portfolio Selection”.
In 1990, Markowitz won The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel – the “Nobel Prize in economics”- “for … pioneering work in the theory of financial economics”. He is one of a number of preeminent financial economists and behavioural scientists whose contributions to the development of how investment markets work have been recognised with the Nobel Prize.
Our investment approach is summarised by the following four principles:
- Markets work – rather than trying to outguess the market (i.e. investment markets), let it work for you;
- Risk and return are related – Only take risks that research has shown to have been reliably rewarded in the past and can expect to be rewarded in the future;
- Diversification is key – Invest in broad based asset portfolios of every asset class where risk is rewarded over the long term in a strong and reliable manner; and
- Structure explains performance – Asset allocation is the key determinant of the variation in investment portfolio returns: the rest is “noise”.
Principles 1. and 2. relate directly to the research of Professor Eugene Fama of the University of Chicago, a recently announced joint recipient of the 2013 Nobel Prize in Economic Science. Fama’s award has been a long time coming – his contributions to financial economics over an almost 50 year period have been unparalleled [1].
Fama’s findings contradict active funds management
“Markets work” relates to Fama’s thesis that financial markets are informationally efficient. This means that current prices of financial assets summarise all information about the future i.e. they reflect a consensus of all existing knowledge and speculation.
Often, critics of this “efficient market” view interpret it to claim that market prices are “correct” – whatever that means – and, having built a straw man, proceed to knock it down.
It is impossible to prove that markets are efficient in the Fama sense. But key implications, that are critical for investment practice and have been supported by study after study, include:
- Simple share trading rules don’t reliably work;
- Fundamental analysis, to indentify over or undervalued shares, is not a worthwhile endeavour; and
- New information is incorporated into asset prices almost immediately, so there is no benefit to be had from trading on yesterday’s news.
There is a large active fund management industry and vast financial media that don’t like the efficient market message. It means that, on average, what they offer is not worth paying for!
But 40 years on from Fama’s original exposition of the concept and ongoing attempts to find and exploit anomalies, market efficiency remains a foundation for financial economics’ research efforts. The good news for individual investors is that it means you can rely on the current price of a financial asset as the relevant market’s best assessment of its value – you don’t have to worry about being at a disadvantage to someone having more knowledge and expertise than you.
The second principle, “Risk and return are related” doesn’t appear particularly profound. But Fama, together with Professor Ken French of Dartmouth College, shone a light on the types of risk that are most likely to provide the highest returns.
While it had long been recognised that there was an expected (but not guaranteed) premium for investing in the share market rather than cash, because of the greater risk, the Fama-French research revealed an additional expected premium over that provided by the share market for investing in small shares (compared with large shares) and value shares (compared with growth shares). These small and value premiums are compensation for additional levels of risk above that already inherent in the total share market.
The Fama-French 3 factor model (i.e. the total market, small and value premiums), as it has become known, is now the benchmark for examining fund manager performance. If an equity fund manager has outperformed the market, the model enables an assessment to be made regarding whether the outperformance is due to skill, luck, or more often than not, an unwitting tilt to the small and/or value factors.
When put through the 3 factor filter, a number of so called “Smart Beta” strategies (e.g. fundamental indexing, low volatility) that fund managers have been recently promoting are revealed to be not so “smart” but poorly constructed tilts, primarily, to value.
Schematic of Fama/French 3 Factor Model
The 3 factor approach allows investors seeking higher returns to take additional risk in a manner that is most likely to achieve increased returns. By implication, investment approaches that offer additional return without resorting to these risk factors are almost certainly unsubstantiated and/or taking more risk than necessary to achieve the desired return.
Common “wisdom” not in accord with Nobel Prize winning research
The research of Professor Fama and other Nobel Prize winners in the field of financial economics has provided robust insights into the pricing of financial assets. Their findings often don’t accord with common “wisdom” nor with what many in the fund management industry and financial media would want you to believe.
In most fields of human endeavour, the smartest earn the highest rewards. In highly competitive financial markets, the presence of so many smart people ensures that there is no easy money to be made by anybody. The work of Professor Fama and others provides the foundation for an evidence based approach to investment that puts the odds of success in your favour. In particular, it indicates you are likely to be better off by:
- not trying to beat the share market (i.e. “markets work”); and
- only taking risks that research has shown to be reliably rewarded in the past and suggests will be rewarded in the future (i.e. “risk and return are related”).
[1] Professor John Cochrane, a colleague of Professor Fama, provides a readable summary of Fama’s contribution to financial economics.