In a sweeping conversation at the Fiduciary Investors Symposium at Chicago Booth School of Business, celebrated professor of finance Eugene F. Fama shared his thoughts on stock picking, private equity and the challenges facing democracy.
Stock picking is not a solution to today’s challenging investment environment, warned Eugene F. Fama, The Robert R. McCormick Distinguished Service Professor of Finance and 2013 Nobel laureate in economic sciences, best known for his empirical work on portfolio theory, asset pricing and the efficient market hypothesis.
Speaking at FIS Chicago the so-called father of modern finance said stock picking and active management run counter to diversification, key in the current climate.
“If you are an active manager you are not diversified,” he said. Moreover, successful active management depends on the challenge of accessing specific and unique information that isn’t in the market and no one else possesses.
“I don’t know anyone who has that information,” he said.
Inflation and Central Banks
Fama was sceptical of the ability of central banks to curb inflation with higher interest rates given the scale of QE over recent years. It is unknown how far rates will have to rise to curb inflation given the trillions in free reserves in the system. Compared to previous inflationary cycles he said.
“QE is a different ball game; I’m not sure how they are going to do it. Who knows? It’s a new experiment. We’ll have to see what Central Banks can do but I don’t think they can do very much.”
Nor does history suggest central banks are skilled in managing inflation. When inflation was at historic lows, the Federal Reserve was unsure why, or how, to tackle it. Elsewhere, he said the high inflation and interest rates that defined markets in the 1980s came on the watch of policy makers who should have known better.
Fama advised investors to focus on diversification and how much risk they are prepared to take – a process that is complicated by the deafening noise in financial markets. Investors are also battling decision making against the backdrop of statistical uncertainty. There is so much uncertainty around true expected values and variance rates are so high, analysis of short periods of time doesn’t tell investors much.
For those wanting to avoid the uncertainty of equity markets he suggested short term bonds, and flagged the volatility and tail risk of emerging markets. Although he noted the diversification benefits of emerging market equities, he warned that looking at individual countries reveals stark volatility.
“Data never includes the markets that blow up,” he said.
Fama said new research has appeared on the fringes, but he argued that few new ideas are emerging in finance and nothing has altered his key beliefs. He noted the continued integration between macro- economics and finance. Casting back over his career, he said he benefited from so much being new and undiscovered when he started out. Early research included the risk of stocks versus bonds and developing a database for public securities.
Fama flagged challenges around private equity investment. He warned that investors rarely see the full data on private equity allocations that have failed, and it is similarly difficult to ascertain why other investments succeed. Noting “most [private equity investments] fail, some do well,” he said it is difficult to see what leads to high returns because private equity lacks the data attached to traded securities. He noted that private equity investors may be told what something is worth now, but without selling the asset it is actually impossible to really know its worth.
The absence of data also feeds into his concerns about the rise of ESG investment. Fama argued that companies integrating ESG are not necessarily acting in the interests of shareholders. If governments want to integrate ESG they should back it in law rather than leave it to corporate choice, he said. He counselled against individual companies having multi-dimensional objectives that they can’t evaluate and stressed that laws should determine how business approaches ESG.
“You need the legal framework to make it work; you don’t want companies making those decisions.”
He questioned if companies most exposed to fossil fuels have actually seen their value decline, and said that land values in countries like Canada less subject to the impact of rising sea levels have not risen in line with the imminent threat of global warming. He highlighted a huge range of uncertainty in climate change and the speed of its approach.
“It’s much more complicated than the media says,” he said.
Fama poured cold water on the rise of crypto: as long as it is not used as a medium of exchange, crypto has no value. He says crypto currently has no basis in reality – and monetary theory teaches that something that is highly variable shouldn’t be a medium of exchange: companies want a medium of exchange to be predictable but no cryptos are – even those supposedly pegged to the dollar have exploded.
“Crypto bothers me a lot; it’s non-sensical,” he said, adding that it could knock companies out of business if they were trying to take payments in crypto.
Crypto currencies are distinct from CBDCs. CBDCs are a way for individuals to clear their trades through Central Banks directly rather than via local banks, changing the payment mechanism. He said the medium of exchange would still be the dollar.
Fama voiced his concerns that society is increasingly removed from reality as people fail to understand what is good and what isn’t good. This led to the rise of Trump and further afield, now threatens Chile’s constitution. Fama called Trump dangerous, a man who put his own value above the value of the country and its institutions. He said the only reason Trump won the presidency was because he was running against Hilary Clinton.
He said democracy is threatened by a lack of education and the rise of trend followers.
“Nowadays, everyone can be educated,” he argued. Regarding inequality, he outlined the importance of incentives driving human behaviour, comparing this to a socialist country “that doesn’t function very well.”
Closing the conversation with more thoughts on active management, Fama stressed the role of luck in investment performance. Investors that have done well in the past may not do well in the future so should not be compensated on past levels.
“There is a problem when it comes to differentiating between luck and skill,” he said.
He added that active managers make [market] returns less efficient – the market could be more efficient with fewer active managers. Trading is getting faster; the uniformed are pushing asset prices around in another reason to be diversified. He said the market didn’t look any more or less efficient today, despite the availability of data.
Still, he warned against being too quick to see trends and certainties in data now available through AI and big data. He warned that it is possible to see data as systemic and see things that aren’t there. “They look like they are there but they are only there by chance,” he concluded.