One week to the day before he was awarded a Nobel Prize in economics, an unrepentant Eugene Fama last week sat down for an interview with John Nersesian, managing director at Nuveen Investments, at IMCA's Advanced Wealth Management Conference in Chicago. Fama’s scornful views on hedge funds diverged sharply with his take on private equity, a vehicle in which he believes human capital at the management level can make a real contribution to higher returns.
The 74-year-old Fama is best known for his efficient markets hypothesis and he wasn’t about to flinch when confronted by skeptics. For many financial advisors and their clients who lived through the 2008-2009 financial crisis, the concepts of almost perfectly efficient financial markets and modern portfolio fly in the face of reality, not to mention historical experience.
Advisors are hardly alone. Several years ago, Research Affiliates founder and fundamental indexing advocate Rob Arnott wondered aloud at an Inside ETFs conference how the normally rational folks at Standard & Poor’s could have inserted such fledgling companies as Sycamore Networks and Copper Mountain Networks into the S&P 500 at the height of the tech bubble in the late 1990s. If sober people on the S&P committees can get bamboozled by the mania of the moment, how many people have the discipline of a Warren Buffett to sidestep a bubble.
Be that as it may, Fama acknowledged on October 7, the markets are not “perfectly efficient,” but they do represent a good model of the world.
But what about during periods when markets drift to extremes beyond several standard deviations of normalcy as they did in the financial crisis and the tech bubble?
Fama, considered the father of modern finance, wasn’t buying it. Au contraire. In his view, the markets were “demonstrably” efficient in 2008. Advisors and their clients didn’t like what they saw, but he believes that the role of the markets are to fall at the onset of a recession and to signal a recovery ahead of time by starting to appreciate prior to the turnaround.
In that sense, he is right. Markets bottomed in March 2009 and were rising by the time the recession was over two months later.
However, Fama conceded there were so many “misconceptions” pervading popular thinking during the financial crisis he tried to avoid talking about them. One pivotal question was the causality factor. Did markets cause the recession or vice versa? Obviously, the advent of new financial instruments like credit default swaps magnified the problems, but government policies dating back to the early 1990s played a key role as well.
More than a few financial advisors threw in the towel on Modern Portfolio Theory (MPT) during or after financial crisis, but Fama viewed it as valid as ever. “Diversification is your buddy,” he said, and added that MPT is as true today as it was in 1953 when Harry Markowitz wrote his famous dissertation.
Perhaps the most surprising aspect of Neserian’s interview with Fama was his divergent views of hedge funds versus private equity. “Forget hedge funds,” Fama counseled. Given the incentive compensation structure and leverage flexibility, they have every incentive to use 2.5 times leverage—which increases the range of outcomes by a factor of 3—and to swing for the fences. The result should be that they earn very high average annual returns for several years before vaporizing all their investors’ money.
Fama related the story of “good friends” who have started hedge funds and failed three times. “Reputational theory” says they should only be able to do it once.
Nersesian noted that they must be good at something. “Losing money” was Fama’s response.
Private equity is an entirely different matter, although Fama described it as a “high variance activity” with access to a tiny segment of the market. “They provide management,” which is human capital that may or may not be far more valuable than investment management. Whatever the result, the risks are “enormous,” partially explaining the wide dispersion of returns.
Finally, Fama was asked what he thought of the financial advisory business. Here, he had some kind words, noting that he knew people who had very satisfying relationships with their financial advisors.
But Fama maintained that investors should be aware of what they sacrificed when they retained an advisor. A 1% annual fee translates into one-third of the value of a stock with a 3% dividend. Most successful advisors, he claimed, moved out of investments and into wealth management where they addressed a host of client issues ranging from retirement, taxes to estate planning and other disciplines. The investment part of their value proposition is dubious in his view, since Fama noted it can be replicated for just a few basis points