Eugene F. Fama, the winner of the Nobel prize for economics in 2013, is well known for research on markets, particularly the efficient markets hypothesis. He focuses on the relation between risk and expected return and its implications for portfolio management. His work has transformed the way finance is viewed and conducted.
Professor Fama was in India recently for NSE’s Dr RH Patil Memorial Dialogue 2020 where he shared his views on a wide range of topics that will be of much interest to Indian investors.
On relation between behavioural finance and efficient market hypothesis
Behavioural finance is really a branch of efficient markets. “I always say I’m the most important person in behavioural finance because without me they have nobody to pick on.” When a professional manager does not beat the market, those supporting behavioural finance will say that he is dumb. But EMH will says prices take time to adjust to information. “We take the same facts and interpret them differently.”
Professor Fama thinks that parking money in index funds is a better alternative. He thinks that passive investing is a “better outcome and a cheaper outcome” because the discretionary or the active managers use their judgements way more than the passive people to make money. But he thinks that some informed active investors are needed to keep the market efficient. “The problem is most of the professional managers just don’t seem to be particularly informed.”
Efficient market theory and asset pricing models
There are two pillars of asset pricing; one is efficient markets that is just information. The other is risk and return is where asset pricing models. How do you measure risk? What is the relation between expected return and risk? So the question about small stocks and value stocks is not really about efficient markets. It is really about risk and return at least we have these real dimensions of risk which get compensated in the expected returns.
Investing in Covid environment
To the question, should investors go for growth or value stocks in this environment, professor Fama thinks investors should go with the market (invest in index funds or ETF). “If you don’t know risk and return you should just probably stick with the market.”
On ESG investing
Prof. Fama thinks that investors and fund managers are not very clear about ESG investing. If investors turn towards environmentally-friendly or socially-friendly stocks, they push up the prices and lower their expected returns. Investors are saying that the choice has its own reward and expect that they are going to get higher returns from doing that but that may not really happen. People may pay more for products that are produced in an environmentally friendly way but will they pay more for stocks that belong to companies that stick to ESG principles?
The other big issue is, how to value in a world where they have ESG goals as profitability goals. They can say that profitability will be lousy but they are ESG compliant. I don’t know how those decisions would be made. I don’t think regulators, especially in Europe are thinking about this very well either.