Active fund management is a zero-sum game in which luck and skill are virtually indistinguishable, says Nobel Prize-winning economist Eugene Fama.
Fama, a University of Chicago finance professor and a co-winner of the Nobel Prize in economics last year for his efficient markets hypothesis, spoke to an audience of financial advisors and institutional investors on 18 September 2014 at the Morningstar ETF Conference in Chicago.
He said that passively managed investments such as index-based mutual funds and ETFs merely reflect the market. Therefore, in order for some active managers to beat the market, other active managers must lag it. Why they beat or lag the market is another matter, Fama said. “The good ones might be good, or they might be lucky. The bad ones might be bad or might be unlucky. You can’t really tell the difference,” he said.
Moderator Ben Johnson, Morningstar’s director of passive funds research, asked Fama how he would explain Warren Buffett’s remarkable success as an active manager. Fama responded that if one were to look at the broad range of performances across all CEOs (Buffett is CEO of holding company Berkshire Hathaway (BRK.B)), one would find some at the top end and others at the bottom. He stopped short of attributing Buffett’s success to luck, however.
The lower fees typically charged by index-based funds are often cited as a reason they tend to outperform their actively managed counterparts, and Fama said his research supports this notion. He said that, before factoring in fees, about 50% of active managers beat their index, adding “but that’s exactly what you’d expect by chance.”
Asked whether active managers contribute to market efficiency, Fama said, “There’s this fallacy that people have that says you need active managers to make the market more efficient. That’s true to some extent, but you need informed active managers to make it more efficient. Bad active managers make it less efficient.”
“The question is, when is active management good?” he said. “The answer is ‘never.’”
Fama on Factors
Fama also was asked his thoughts on the subject of risk, which he called “a complicated thing.” He spoke about the idea of isolating various risk factors within a portfolio--sometimes called strategic beta or smart beta strategies--and said that, while real, such “dimensions of risk” are still not well understood. He said such factor-based investing works, “But why? All we know is that they seem to be there.”
He also said that combining factors can be counter-productive, adding that “once you get beyond two dimensions of return, the third adds very little.” He offered value and momentum as examples of factors that can work against one another within a portfolio.
Fama dismissed an audience member’s question about tactical management of risk, saying, “You’re talking about market-timing. I don’t think there’s any evidence that that works either.”
Fama said he has no problem with investors using factor-based strategies to shape their portfolios but suggested doing it “in a cap-weighted way” in which holdings that meet the factor criteria are held in proportion to their market capitalizations.
He said he doesn’t recommend any specific allocation strategy, but said “you pick your risk exposures and then you diversify the hell out of it. That’s the best you can do.”
As for his own portfolio, Fama said he primarily owns equity index funds and some Treasury Inflation Protected Securities (TIPS), adding that he has no interest in real estate or bonds.
“I’m a tenured professor,” he said. “The university issued me a bond.”
