Passive beats active management

Nobel Prize-winning economist Eugene Fama on effectively efficient markets


The stock market plunge of 2008 preceded a recession, which is normal; the reason equity investors earn a risk premium is because “the probability is quite high that they are going to lose”, and nearly 100 per cent of fund managers would have been driven out of business had their fees been related to performance.

There is both bad news and worse news for clients of active investment managers. It is a zero-sum game, because every winner must be matched by a loser. What is worse, it becomes a negative sum game once costs are taken into account.

Professor Eugene Fama, joint winner of the 2013 Nobel Prize for Economics, combines highly original thought with a powerful talent for exposition.

They awarded the prize to him and fellow laureates Lars Peter Hansen and Robert J. Shiller “for their empirical analysis of asset prices”, and it is perhaps for his work on market efficiency that he remains best known. The judges note that Professor Fama showed that short-term stock-price movements are impossible to predict and that they respond almost immediately to new information, “which means that the market is efficient”.

Is that still his view or has it changed?

“It hasn’t really changed because I never put it forward as an absolute,” he replies. “It is a model, a very good approximation of reality but not reality itself. I think it’s a very good approximation. In fact, of all the models that we have in economics, I think this one probably has worked better than any other one I can think of.”

A fair number of observers found their faith in the efficiency of markets shaken by extreme events such as the 1987 share-price crash, the bursting of the tech bubble in 2000 and the price slide of 2008. To them, such events offer proof that, over time, markets are irrational, rather than rational. Professor Fama is having none of it.

“The market did what it typically does in advance of a recession – it went down a lot. I think it is doing its job when it performs in that way.

“It is the case historically that market volatility increases when we are heading into bad times and that it is lower when the good times return. Right now, we are in a period of relatively low volatility. The key point is that none of this is inconsistent with the notion of market efficiency.”

Fashionable factor investing

Asked whether the premiums from factor investing could fall as more and more money is dedicated to pursuing factor-based strategies, he said: “Finance is no different from any other branch of economics. It is all about supply and demand, so if demand goes up the price goes up and expected returns go down.”

Factor investing, he says, has a reputation for “being somehow high-tech stuff”, but while it is not necessarily easy to implement from a trading perspective, it is really brutally simple minded and not technically sophisticated. “Basically you’re just following particular rules for the formation of portfolios.”

He adds: “All this ‘factor’ stuff has made its way into the market too quickly as far as I’m concerned. It hasn’t been subjected to the sort of robustness checks that I would have liked to have seen before people became locked on to it.”

On portfolio construction, Professor Fama says: “The basic rule is that diversification is your buddy. Whatever you do, make sure you do it in a highly diversified way.”

Active versus Passive Management

The debate on active versus passive investment strategies shows no sign of abating, and the UK regulator, the Financial Conduct Authority, has turned the spotlight on the asset management industry in Britain, concluding that there is little, if any, relationship between fund performance and the fees charged.

In June, the FCA said: “Despite a large number of firms operating in the market, [our] analysis found evidence of sustained, high profits over a number of years. [We] also found that investors are not always clear what the objectives of funds are, and fund performance is not always reported against an appropriate benchmark.”

Let the market regulate

Some have suggested regulators, such as the FCA, or even legislators ought to act in this area, but Professor Fama is characteristically straightforward: “Just leave it to the market.”

Not that voluntary initiatives such as Fidelity’s recent announcement of a major overhaul in its charging structure to introduce performance-related fees are without their dangers, he warns. “That’s a good way to go, but if the firm had done this historically they would be out of business by now. So would the whole industry. Ken French and I have estimated that 97 per cent of the actively-managed mutual funds do worse than you would expect by chance.”

Professor Fama’s scepticism about the benefits of active management is well known, but he insists that “it’s not scepticism, it’s arithmetic.”

If passive investors hold portfolios of stocks weighted according to their market capitalisation, they have no dealings with active managers. So if some active managers win by holding unbalanced portfolios, there has to be somebody on the other side [who loses] and who is by definition another active manager.

“So, active management is a zero-sum game before costs. After costs, it has to be a negative-sum game.”

We need active managers for efficiency

But suppose all managers became passive index trackers. Would prices stay efficient? “No, they would not. You need good active managers to offset the bad active managers, to make prices more efficient. If some of the bad ones drop out, you need fewer good ones because there are fewer errors to correct. Nobody knows precisely how many active managers you need to keep the market efficient.”

Professor Fama warns that these good managers may tend to keep the rewards of their efforts rather than share them with investors. “If I am a good active manager, that is a human-capital skill. Rewards should go to the human capital, not the investor.”

His advice? “Investors should be not just sceptical but really suspicious that they will ever get anything out of this.”

The Future of the Asset Management Industry

They should also bear in mind the difficulty of distinguishing between skill and luck in the performance of an active manager. “People don’t understand that the volatility of asset returns is so high that past performance is almost irrelevant in terms of judging what the future performance is likely to be.”

What of the medium-term future for the asset management industry? Does he speculate about the likely shape of the sector in ten or 20 years’ time?

“Not really. The scale of change during the last ten years shows how rapidly things can move but efficient markets didn’t really make any penetration for a long time so it’s kind of discouraging. That said, I think active managers are going to have to compress their fees, bringing them closer to those charged by passive managers.

This will be prompted, in part, by increasing customer scepticism about the performance of active managers.”

Adding to the squeeze on revenues for active managers, he said, is likely to be a move from active managers into trading based on algorithms, although Professor Fama notes: “There is more marketing in financial management than real high-tech stuff.”

He ends on a self-deprecating note: “The excitement in the fund-management business is to see what the surprises are as you go along. I have no ability to predict directions or trends.

“Any time I’ve ever tried to do that I’ve been uniformly wrong, so I don’t do it anymore.”

Stephen Schaefer and Eugene Fama were in conversation at the 3rd annual Insight Summit conference held by London Business School’s AQR Asset Management Institute. The event took place on 7 November 2017 on the theme of Intelligent Risk Taking.

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