Indexing And The 2013 Nobel Prize For Economics

February 09, 2014

David Blitzer

2013’s Nobel Memorial Prize in Economic Sciences was awarded to Eugene Fama and Lars Peter Hansen of the University of Chicago, and Robert Shiller of Yale University for their contributions to understanding asset prices. Among the practical applications of the contributions by the laureates, indexing and index investing stands out.

Fama is best known for the efficient market hypothesis (EMH), which says that predicting stock prices is virtually impossible; therefore, indexing is a preferred investment strategy. He is also widely recognized for work with Kenneth French of Dartmouth that includes the three-factor model showing small-cap and value effects. Most investors will recognize Shiller as the author of “Irrational Exuberance,” which predicted the 2000 tech bust and, in a second edition, the housing boom and bust. His work includes analyses of the predictability of stock prices over long time periods based on a version of the P/E ratio. Lars Peter Hansen’s work is primarily in econometrics and provides the tools to examine many of the theories developed by Fama, Shiller and others. The work of all three of this year’s laureates builds on research in finance and asset pricing extending back to the early dividend discount models, mean variance optimization, the capital asset pricing model and other efforts to combine market data with finance theory.

The growth of indexing and index investing strategies is also the product of a combination of data, experience and theoretical ideas. Among the arguments in favor of index investing, the three most common are low cost; the difficulty of consistently picking winning stocks; and the idea that the cap-weighted market portfolio is the efficient balance of risk and return. Whether index investing is consistently low cost is an empirical question; most comparisons suggest that it is.

Fama’s work on the EMH argues that all available information is incorporated into stock prices almost instantly, that prices reflect all known data and therefore that stock picking is a fruitless exercise. One implication is that investors might be better off indexing their portfolios and devoting their efforts to other pursuits. These ideas were extended to distinguish different sources of information and suggest that inside information might make stock picking rewarding (as well as illegal). Many of the tests of the EMH used event studies—examining how quickly stock prices react to pertinent new information such as dividend announcements. These efforts supported the EMH. Studies of the index effect—how a stock’s price reacts when the stock is added to a widely followed index like the S&P 500—add to these findings. The price responds, typically gaining around 5 percent in the few days between announcement and implementation and then giving back those gains in subsequent weeks. These observations support the EMH.

 

 

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