Embrace passive management already

Some advice from the father of efficient markets

Credit: Michael Byers

Eugene F. Fama | Nov 27, 2017

Sections Finance

Chicago Booth’s Eugene F. Fama weighs in on market efficiency, active management, and corporate governance, among other topics, and explains why investors shouldn’t buy hedge funds.

 

On efficient markets

People say, “Information is much more available. We have the internet. We have much faster computers. Are markets more or less efficient than they were in the past?” I can’t tell. They’ve always looked very efficient. I don’t see any improvement or degradation.

On active versus passive investing

There is no debate whether active management is better; it can’t be. That’s a matter of arithmetic, not a hypothesis. A simple way to think about it is: active managers can’t win at the expense of passive managers, because passive managers hold cap-weight portfolios of the entire market or of subsets of the market—which means, they don’t really respond to the actions of active managers.

On factor investing

Forget timing factors. That’s ridiculous. A company that I’m involved with [Dimensional Fund Advisors] does it passively. They just buy the whole value segment of the market, or the whole small segment of the market. They’re not trying to pick winners or losers. Timing is even more subject to error than picking individual securities.

On financial products

In academic finance, there are three to five ideas that survive every 20 years. In marketing and applied finance, there are 10 new products a week. But the key to all of it is robustness. People are too ready to come out with products based on things that are flimsy statistically. When academics do stuff, we always look for other time periods and go to other markets to see if we see similar things. If we don’t, we don’t trust them. If they have absolutely no relation to theory anywhere, we don’t trust them. 

On market structure

We have competition among markets now. That’s the way you want to see it. Let’s see what survives out of all of that. Governments are never in a good position to regulate things like that. I mean, insider trading, maybe. But actually regulating the mechanisms of the market is tricky because they change so fast.

On corporate governance

It’s better than it was because of the professionalization of investment and the fact that we have investment managers who take it seriously. Passive funds have gotten big enough that they realize they have responsibility to their investors. They want to deliver value. They don’t want the value to be stolen by the insiders, so they’re into corporate governance. I mean, at Dimensional, we have 20 people that just do corporate governance. I think it’s probably similar at other places. We have rules such as: if a board member of a company votes in favor of a poison pill, we’ll follow that director for the rest of his life and vote against him no matter where he goes.

On active managers

Being good at active management, that’s a human-capital skill. That person is going to charge high enough fees to absorb the rents that she’s creating. Investors are always going to be just as well-off buying passive, even if they can identify who the good active managers are.

On financial advisers

When Dimensional started dealing with financial advisers, I said to them, “Your business model has to change because just doing portfolio management is not worth 1 percent a year. You’re going to have to get into other aspects of the business. You’re going to have to do general wealth management and, maybe, life insurance, accounting, all kinds of other things.”

The adviser business has definitely moved in this direction. The fees for financial advisers are getting negotiated downward. I don’t think there’s much 1 percent any more, except at the low wealth end.

On portfolio construction

When I talk to institutional investors, I like to chide them that they change their portfolio allocations based on three to five years of past returns, and that’s basically noise. There’s no information from that about expected returns.

On proposals for transaction taxes

I hate them. The more you interfere with markets, the worse off you’re going to be.

On robo-advisers 

In the end, these are going to be a boon to professional advisers. They’re going to be a way advisers can show their clients what distributions of outcomes possibly look like with different investment strategies. 

I play a lot of golf with a lot of rich people. When I talk to them about their portfolios, they don’t want to bother with them, basically. They want an adviser, and they do not want to be involved in investing on a day-to-day basis, because their value added is somewhere else. I don’t think that’s going to change. These robo-things are just a technology tool that will help advisers in the end, not hurt them.

On algorithmic trading

It could make the market more efficient, or it could lead to problems. Lots of it does seem wasteful. All of this investment and capital to just be a microsecond in front of everybody else seems a bit wasteful.

On market regulation

When the NASDAQ market came online, there was a quiet period, and then in the late 1970s, early ’80s, they loosened the listing requirements. Now, they didn’t do that on their own. There was a demand for it. They figured out that people were willing to hold companies that weren’t profitable when they went public. There was an explosion in listed companies—and listings grew until about 1996. Since then, the number of listed companies has fallen dramatically. I think it’s 30 percent lower at this point than it was then.

You say, “Maybe there were too many listed companies.” But the really frightening part of it is that it’s also happened for nonlisted companies. If you look at business formation, it’s tanked in the same period. And that’s where the dynamics of the economy really sit. This has a lot to do with regulation. It’s just so hard to start a business. It’s so expensive. You can’t go into the financial business now without having compliance from day one, which means you have to have a certain amount of capital that you didn’t need 30 years ago. So it’s much more difficult to start a financial business, and I think that’s true across the board.

Unwinding all of that, my preference would be that every regulation has to be renewed every three to five years, otherwise it lapses. Of course, nobody listens to me!

On private equity

The private-equity market has expanded into somewhat bigger stuff, but that’s different from market efficiency, in the sense that people can have good ideas and not be able to manage a company, or have the capital to implement their ideas. A private-equity company can provide both these things, management and capital. I have no problem at all seeing higher returns to private equity. The problem is, you can’t measure the returns to private equity because they’re all self-reported. You don’t get to see the bad ones. 

Again, there’s a warning because this is a human-capital activity. When it works well, the returns should go to the private-equity managers, not the investors.

On hedge funds

If you want to get poor quickly, you should go into them. If you believe the arithmetic of active management, why would you pay anybody 2-and-20 [2 percent of total asset value, 20 percent of any profits]?

I’ve never been able to explain why these things exist. They demonstrate, absolutely, the phenomenon of money moving quickly based on noise. . . . You expect extreme returns, one way or the other. After you take off the 2-and-20 you expected, on average, you’re going to be down. Because hedge funds are subject to the arithmetic of active management, they’re part of that game.

On changes in academic finance

In the 1960s, there were two places doing serious research, Chicago and MIT, as well as Carnegie to some extent. But now, every university has a pretty good finance group with really good people in it and they’re all doing similar sorts of things. The challenge is to figure out what is the result of data dredging and what is the result of something real. But that’s a good challenge to have in the sense that you’ve got a lot of talented people out there doing really good things.

On building a financial business today

I would focus on providing a full range of products, not simply investment products but financial management or wealth management products. Estate services, maybe even tax services—all of that—and portfolio management, I think, can be done as a part-time activity. 

What an adviser has to do in rebalancing portfolios, that’s not really a full-time job if you have a pretty clear picture of where you want to be and how to get there. But the rest of it is, or can be, a full-time job. So that’s what I would do if I were in that end of the business.

If I were in the institutional end of the business, hiring people, what I’d say is, “Cut the staff down and go passive.” I’ve been saying that to the university’s endowment for 50 years. They’ve never followed my advice, and it would be a much bigger endowment now if they had.

 

Eugene F. Fama is Robert R. McCormick Distinguished Service Professor of Finance at Chicago Booth. This was adapted from a dialogue at the CFA Society Chicago, where Fama was interviewed by Kepos Capital’s Bob Litterman.