“Stock prices reflect all available information.”
This simple, yet profound concept spawned in the 1960s continued to evolve into more sophisticated asset pricing theories and has won Eugene F. Fama, “Father of Modern Finance,” the 2013 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.
What are the implications of Fama’s Nobel-prize winning notion? It all boils down to the fact that it’s impossible to beat the market on a consistent, short-term basis. This revolutionary idea sparked a movement toward the creation of investment products based on the market-and index funds were born.
The early leaders of the index funds movement were two of Fama’s students at the University of Chicago: David Booth and Rex Sinquefield. Independently, the two developed the first S&P 500 index funds, which were first available only to institutions.
Fama’s extensive research on market efficiency begged the question: If you can’t beat the market because prices quickly reflect all available information, where do excess returns come from in the longer term?
He, along with Kenneth French, analyzed all stock market information going back to 1928 at the Center for Research in Security Prices (CRSP) and determined that additional “risk premiums” had been identified in addition to the “market premium.” A portfolio’s deeper exposure to the small corners of the market, and to the more value-centric companies, or those with a high-book-to-market ratio, have delivered returns above the market. These additional risk premiums, however, are not “freebies,” but rather, additional expected returns for additional risk factor exposure. This asset-pricing theory put forward in a 1992 journal article became the most cited paper in financial economics and is today commonly known as the ‘Three Factor Model’ and is what won him the 2013 Nobel.
When Fama was interviewed shortly after he learned he won the 2013 Nobel he was asked, “What fundamentally would you say is the relevance of your work to the world at large?” Fama replied, “Well, for this particular area, the idea is really ‘how do you measure risk? And if the market is pricing things correctly, what is the relation between the expected return, which is the compensation for risk, and the risk.”
Forty years after the first S&P 500 index fund was created, thousands of such funds are available to investors in the form of no-load index mutual funds and ETFs. As to Fama’s and French’s discoveries regarding the small and value premia, Sinquefield and Booth capitalized on Fama and French’s academic research-launching an investment fund company designed to deliver products based on their findings. In 1981, Dimensional Fund Advisors (DFA) was formed and Fama was the company’s Director of Research. Fast Forward to today; DFA has roughly $300 billion in assets under management, with both Fama and French delivering their academic findings from theory into practice.
Their active and ongoing research continues to inform DFA’s investment methodologies. In 2012, Fama and French updated their Three-Factor model to include a fourth factor: Profitability. And just a few weeks ago, a fifth factor was added: capital investment. With two factors for fixed income (term and default), Fama and French have identified seven risk factors that explain the vast majority of stock market returns over time.
Four decades after his simple, but elegant notion inspired an indexing revolution, True Wealth Design celebrates and congratulates Eugene Fama on his Nobel Prize, knowing full-well, however, that the real winners are the global markets’ investors who have the opportunity to confidently buy the markets in low-cost, risk-appropriate ways through index-type mutual funds.
