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Indexing Trumps Luck or Skill, Fama Tells Morningstar Conference

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CHICAGO – With U.S. stocks at record highs, there is no substitute for indexing and diversification if advisors and investors hope to achieve better returns, famed investment theorist Eugene Fama says.

Some money managers may outperform short-term, but “you can't tell good luck from good skill, or bad luck from bad skill," says Fama, a co-winner of the 2013 Nobel Prize in Economics, speaking Thursday at the annual Morningstar ETF Conference.

"There's this fallacy that you need active managers to make the markets more efficient," he says. A better strategy: "You pick your risk exposure and then you diversify the hell out of it," says Fama, the finance professor at the University of Chicago Booth School of Business who gained renown for developing the efficient markets hypothesis of investing.

Even Warren Buffett, America’s best-known stock picker, has lauded the benefits of index funds. “He’s like my hero,” Fama adds, “because what he says is, ‘I can pick a company every couple of years, but if you have to form a portfolio, you’re better off going passive.’ ”

When Ben Johnson, a Morningstar research director who was the moderator, noted that investments devoted to index funds have been rising sharply, Fama interrupted to say, “Finally! … As far as individual investors are concerned, they’re clearly so much better off buying passive products than they are buying active products.”

Regarding another continuing trend – the drop in expense ratios – Fama said in a brief interview with Financial Planning: “It’s an important development – lower fees are better for investors, that’s for sure.”

As for his own money, Fama, 75, says he’s moved some of his portfolio into TIPS given his age; much of his portfolio is in value plays through his involvement with Dimensional Fund Advisors.

Answering audience questions, Fama entertained the crowd with tales of gatherings with his extended family and Swedish royalty after winning the Nobel, as well as his decision to teach his finance class right after learning he had won.

But not everyone was ready to give up active management. One questioner insisted that when an advisor or investor senses an index is headed for a very tough period, such as in 2008, it pays to employ an active strategy.

Fama isn’t persuaded. “You’re talking about market timing,” he says. "If you sold when the market crashed, you made a big mistake. If you saw it coming a year ahead of time, you're a genius." And as his research establishes, there are very, very few long-term investment geniuses.

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