Straight Talk: Fama And French

March 01, 2007

 

JoI: So it's just another way of capturing the value premium?

French: It's not even another way. It's the same way. I have a friend who calls it value investing for clients who don't understand ratios.

Fama: It's a triumph of marketing, and not of new ideas. It's a repackaging of old ideas.

JoI: What do you think of the dividend weighting schemes created by WisdomTree and others?

Fama: That's worse. Of all the measures you can sort by, that one (dividends) produces the weakest value premium.

French: To be fair, what Jeremy Siegel (one of the developers of the WisdomTree indexes) is doing is different. He's not ignoring a huge academic literature and claiming he invented the idea of sorting stocks by dividends.

Fama: Well, I'm not so sure. He does claim this is a "financial revolution." But Bill Sharpe was promoting the idea 20 years ago. And the reality is that only 22 percent of firms pay dividends. What do you do with the rest?

JoI: Have your views on efficient markets changed over the years? Are the markets becoming more efficient with the increased trading volume, etc.?

Fama: I don't think anybody knows the answer to that. French: Stock returns are too noisy to tell. There may be more mispricing now or less, but there's no way to show that.

Fama: I think markets have always been efficient.

French: The reason we can't agree is that returns are too noisy to prove inefficiencies exist. I think there are inefficiencies.

Fama: Well, if you can't measure them, you might as well say they don't exist.

French: The bigger point as it relates to fund management is that I'm willing to concede that there is somebody out there who can beat the market. But returns are so noisy, I can't figure out who it is. And although I think there are some mistakes in prices, I think almost all investors lose when they go looking for them.

Fama: People think it's a one-sided battle. But active managers can have bad information about the markets just as easily as good information, and they can come out the worse for it.

JoI: But to broaden the discussion for a moment: One would think that, when the spread widens between growth and value stocks, investors can better capitalize on the more significant value premium. Do you think investors are able to use the spread to predict markets? Or to time markets?

Fama: There's no evidence that that works.

French: Again, it's the noise in returns that kills us. It's one thing to do a cross-section test with thousands of stocks and say that high book-to-market guys have higher returns. But if you want to say that, when the spread in book-to-market ratios is unusually high, you get an unusually high spread in returns … well, you're only dealing with 78 years of data, so even if that relation exists, returns are so noisy it's hard to see it.

Fama: Yes. Differences in expected growth through time would cause the same fluctuations in book-to-market ratios.

French: People just don't appreciate noise. Academics do, but in the practitioner world, people live or die by the next year's return. We have a student who's operating in the real world, and he says it's a lot like Russian roulette: he knows most of his yearly return is determined by luck, but when you're playing Russian roulette, you care a lot about luck. Over the long haul he expects to win, but in the short run he knows it's almost all luck. But that's a Ph.D. from Chicago. The man on the street-or even a good MBA student- has a hard time embracing randomness.

JoI: What do you think about exchange-traded funds (ETFs)? Fama: They can be great for indexes and index portfolios. I think they're fine. Ultimately, it comes down to the cost: whether it is more or less expensive to invest via an ETF or via a mutual fund.

French: As Gene says, it all comes down to costs.

JoI: What do you think of some of the recent product developments in the financial markets? It seems like there are 200 new pseudo-active indexes and ETFs for every one new broad market fund.

Fama: It will be fascinating to find out how and if these new products actually work, but we don't have enough data to know that yet. It will take a long time for the data to accumulate.

French: One thing that relates to that is the growth of interest in behavioral finance. I have a sense that a little knowledge is a bad thing here. People read about behavioral finance and believe that it gives them a hunting license to go out and try to pick winning stocks, or to hire a manager to do it for them. But behavioral finance does not identify the mistakes in the market. Researchers are simply saying that … well … investors don't behave rationally, so there must be mistakes in the market. It doesn't follow that you can find those mistakes and exploit them.

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