Eugene Fama's shared economics Nobel Prize last week surprised no one except, oh, the few who know the reality of his life's work. The Nobel Committee cited what we know as his and Kenneth French's "efficient-market hypothesis" in rewarding Fama one-third of the prize pie. Efficient-market theory, or EMT, is used everywhere today, but Fama and French's own research later made it all but moot. The real contribution is the "Fama and French three-factor model." Thanks to Stockholm, Fama will be remembered for EMT forever, and the three-factor model will rarely be cited. Such is life -- but investors can do better by Fama.
EMT's revolution Fama, a University of Chicago Booth Business School professor, became the father of EMT beginning with his 1965 paper Random Walks Down Wall Street. It fell to another famed economist, Burton Malkiel, to use the title for his megaseller, A Random Walk Down Wall Street, and spread the word (and reap megaroyalties). EMT states that past stock prices don't predict future movements, because stock prices quickly reflect all publicly available information. Thus markets are "efficient," according to this theory, so investors might as well throw darts -- they can't beat the market.
That was certainly the shot heard 'round the world, though it was a slow-moving bullet. Over time, the finance industry created index funds in respect of, and to profit from, Fama's findings. Most notorious was the poster child S&P index fund. Once that fund came along, nothing else would do. The S&P 500 has become the be-all and end-all of investing benchmarks. Index investing through the S&P 500 can be a good idea, but it has become something people take on faith, rather than questioning.
Another group, the "modern portfolio theory" adherents, simply incorporated index funds selling MPT's asset allocation to investor portfolios. If the practical import was to protect individual nonprofessional investors from the world by keeping a hand on their checkbooks, the financial world did just fine. Let 1,000 index funds blossom! Their low costs? Just add a fee to them so you can make your nut putting your clients in Vanguard funds with 0.20% expense ratios, give or take. Worse, the exalted talisman of the S&P 500 index fund is a flawed idea to start (see "Kill the S&P 500").
The three-factor model Many Nobel economics winners made their reputations on the work that won them the prize. They are understandably unwilling to give up the academic cred that came with their work, and they fight anything that dings their reputations. But Fama and French actually had the curiosity and open-mindedness to mine more data and accept new conclusions. Twenty-seven years after the 1965 paper, they began publishing the results of work on expected stock returns. A result was their three-factor model.
They found a first factor: that small-cap stocks and those with a high book-to-market ratio (now expressed more simply as a low price-to-book-value ratio) tend to outperform the market as a whole. Then, the authors produced two more factors -- woe to the math-impaired -- to adjust for the higher risk premium of lower price-to-book-value small caps. The result was a strong case that 90% of diversified portfolio returns were due to small-cap value stocks, compared with the then-popular capital asset pricing model's 70%.
Tell us something we didn't already know Fama and French's new model took a different path, but it was the academy's acknowledgement of what Buffett and his teacher, Benjamin Graham, had known and practiced since the 1940s and '30s, respectively: Mr. Market is emotional and inefficient. Past performance can predict future results when you buy what has been discarded by emotional investors, is cheap, and offers a margin of safety. Conversely, you can lose money buying what they find popular. Readers of Buffett's 1984 Columbia Business School presentation, The Superinvestors of Graham and Doddsville, already knew these points -- but, hey, academics sniff until the soup has proven ingredients.