Fama’s Nobel Work: Active Managers Fated to Lose

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The work that earned Eugene Fama the Nobel Prize in economics provided the intellectual foundation for index-tracking funds, which have upended stock picking as investors abandon active money managers.

Fama, 74, has argued that financial markets are efficient and that stock-price movements are unpredictable, making it impossible for even professional money managers to gain an advantage. His conclusion that investors would be better off in low-cost funds that track the market’s performance helps explain the success of Vanguard Group Inc., the biggest U.S. mutual-fund company, as well as the rise of passive investments, which had more than $2.6 trillion in U.S. assets between exchange-traded funds and mutual funds at the end of 2012.

“His work has been seminal,” F. William McNabb III, Vanguard’s chief executive officer, said yesterday in an interview with Tom Keene and Sara Eisen on Bloomberg Radio’s “Bloomberg Surveillance.” “A lot of what we have done is based on that work.”

Funds that mimic the performance of markets gained momentum after 2008 when the Standard & Poor’s 500 Index fell 37 percent and investors lost faith in the ability of stock pickers to insulate them from losses. Over the past five years, index funds have been the most popular choice for investors, with assets in U.S. ETFs almost tripling in that period. Investors have pulled about $284 billion from actively managed equity mutual funds, while pouring $243 billion into stock index mutual funds since the end of 2008, data from Morningstar Inc. show.


“Index funds have gone from a whacky fringe idea to the point where they are now viewed as the default investment option for many people,” Russel Kinnel, director of mutual fund research at Chicago-based Morningstar said in a telephone interview.

Some of the most highly regarded active equity managers stumbled in the past decade, a period that included the biggest stock-market slump since the Great Depression. Bill Miller, the money manager best known for beating the S&P 500 Index for a record 15 years before the streak ended in 2006, was hurt in 2008 by a heavy bet on financial stocks. Miller’s Legg Mason Capital Management Value Trust slumped 55 percent in 2008.

Fama, a professor of finance at the University of Chicago, concluded in research done in the 1960s that financial markets were efficient, which meant that asset prices already reflected all relevant information. From that basic idea, it followed that trying to beat the market was an exercise in futility.

Vanguard, based in Valley Forge, Pennsylvania, opened the first U.S. index fund in 1976. The Vanguard 500 Index Fund today has $132 billion. Vanguard, which manages $2.3 trillion, in 2010 overtook Fidelity Investments as the biggest U.S. mutual-fund manager.


“The trend is likely to hold until we see a market in which individual stock picking is rewarded,” Geoff Bobroff, a mutual fund consultant based in East Greenwich, Rhode Island said in a telephone interview.

Fama has had a more direct impact at another mutual-fund firm: Dimensional Fund Advisors LP, where he serves as a board member and consultant. Dimensional, based in Austin, was started in 1981. The firm has over $300 billion in assets and ranks as the eighth-largest U.S. mutual fund firm, Morningstar data show.

“Professor Fama’s groundbreaking work on asset pricing and markets inspired the founding of Dimensional,” the company wrote yesterday on its website.

David Booth, Dimensional’s founder, was a student in Fama’s finance class in 1969.

“He was the first person I called when I started the firm,” Booth said in a telephone interview.


Fama’s research forms the basis for Dimensional’s funds, which differ from traditional index funds by putting more emphasis on finding small-cap stocks, stocks trading at low prices and firms with higher profitability, Booth said. Fama’s research showed those factors were critical to return-on- investment.

In a 2010 paper he co-wrote with Dartmouth College finance professor Kenneth French, Fama raised the question of whether active managers were lucky or skillful. He determined that only 3 percent demonstrated skill, which, he found, is what would be expected purely based on chance.

“The research shows that it is impossible to pick people who can beat the market,” he said in a November 2010 interview with Bloomberg News.


Berkshire Hathaway Inc. Chairman Warren Buffett’s investment success over decades has often been used by critics of efficient markets to show that it is possible to outperform indexes. From the end of 1976 to June of 2013, Berkshire shares gained 23 percent a year compared to 11 percent for the S&P 500 Index. Fama, in a 2012 interview, said he considered Buffett more of a businessman than an investor.

“I don’t know if Warren Buffett is just lucky or skillful,” Fama said in the interview, posted on Dimensional’s website.

Not everyone agrees with Fama’s conclusions. Since 1981, Fama’s fellow Nobel Laureate Robert Shiller has been at the forefront of economists chipping away at the theory of efficient markets. His research showed that investors can be irrational and that assets from stocks to housing can develop into bubbles.

Seth Klarman, founder of Boston-based hedge fund Baupost Group LLC, told his investors in a January 2012 letter that the efficient market theory is plausible at first blush. Klarman, whose firm manages about $29 billion, argued that investors are far from rational and that their herd-like behavior can create asset prices with little relationship to underlying fundamentals.


“Conceptually this picture makes sense,” he wrote. “In practice it simply doesn’t hold up.”

Capital Group Cos., the $1.2 trillion money manager based in Los Angeles, released a study in September that found that its stock-picking mutual funds outperformed their benchmark indexes in the majority of almost 30,000 periods examined over the past 80 years. The company suffered $246 billion in redemptions from January 2008 through September 2013, according to Morningstar, as investors defected to ETFs and index funds.

“There can be a significant advantage to active investing,” James Rothenberg, chairman of Capital Group, said last month in an interview with Bloomberg News.

Over the past 10 years, 41 percent of actively managed U.S. stock funds beat their benchmark indexes, according to data from Denver-based Lipper.


The popularity of indexing has grown steadily over the past decade. At the end of 2012, index mutual funds accounted for 15 percent of the assets in U.S. stock and bond funds, up from 9.6 percent at the end of 2003, Morningstar data show. Among stock funds, index funds accounted for 21 percent of assets as of Dec. 31, 2012; among bond funds they represented 9.1 percent of assets.

U.S. ETF assets have almost tripled since the end of 2008 to $1.5 trillion, according to data from the Investment Company Institute, a Washington-based trade group. The vast majority of U.S. ETFs are in indexed products. Unlike mutual funds, ETFs can be traded throughout the day like stocks.

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