Active Management and the Predictability of Markets Redux: Eugene Fama
Updated: May 17, 2022
According to Moody’s, total assets in passive funds in the US will overtake those in actively managed funds in 2021. In light of this significant moment being almost upon us, I thought it would be interesting to write about the predictability of financial markets - the basis of active management - and some of the key protagonists.
"Our challenge is to be more skilful than other active managers"
That it is possible to add substantially more value to our customers’ portfolios than we subtract from them in fees is the basis of our business. The debate between those who believe that markets are efficient, and thus unpredictable, and those who don’t will continue to rage on, and we, as a boutique active manager, seek to be part of it.
The battle lines in this debate, however, are drawn in a somewhat puzzling way. To the passive world, all those seeking to ‘beat the market’ are fools. Yet I do not denigrate the passive world in the way it denigrates mine. I believe that, for many, passive investing makes sense.
The apparent anomaly lies in differences of opinion with respect to the nature of the ‘game’ being played. To the passive world, investing is a game of luck, so by definition theirs is the only worthwhile approach. Accordingly, they must disparage all others. To the active world, on the other hand, investing is a game of skill, in which there is no ‘house’, only other players. Not everyone, by definition, can win.
If we can be better than, say, three quarters of our competition, we will almost certainly generate returns, net of fees, well in excess of the relevant index or passive equivalent, and thus over time ones that are respectable in absolute terms – it is nice to see our two OEICs now posting alphas, Sharpe ratios, and information ratios well above those of their Vanguard equivalents over three years.
Our challenge is thus to be more skilful than other active managers, then to articulate clearly to our customers our investment approach - success for an active manager relies as much on the power of persuasion as the power of prediction.
The passive world has something to offer because index funds do what they say on the packet – provide index performance. Furthermore, there will always be fund investors who lack the time, tools or inclination to identify skilful active managers and thus for whom an index fund is the sensible option.
It is somewhat ironic however that the constituents of index funds, namely companies, are all trying to do one thing: beat each other. Few would question that this competition is anything other than a game of skill and hard work. The better companies tend to stay at the top, whether in toothpaste, cars, computers, active management or passive management. The ultimate paradox may be that Vanguard is not seeking, like its products, to be average, but to beat iShares!
It would be nice if we lived in a world in which all companies win. Until then, we will continue to strive to beat our competition by a wide margin and in doing so give our customers value for money. This letter and the next three are part of that endeavour.
I begin with a look at the work of Economics Nobel Laureate Professor Eugene Fama, the “father of modern finance”. Although it was Fama who first popularized the idea in 1970 that markets are efficient, aka the Efficient Market Hypothesis (EMH), its origin goes back as far as French mathematician Louis Bachelier and his 1900 PhD thesis ‘The Theory of Speculation’. Bachelier is credited with being the first to model mathematically the random process known as ‘Brownian Motion’, and to associate it with stock prices.
60 or so years later, and following a number of other empirical studies, Fama set out to test systematically whether there were identifiable patterns (non-randomness) in stock prices. In 1965 he reported that shorter term returns were somewhat predictable from previous returns – they had a tendency to move in the same direction – but that the relationship was quite weak. Later, Fama stated that these patterns were so faint that attempts to exploit them would be wiped out by trading costs.
This ‘no-arbitrage’ model formed the basis of the EMH. In the decades since Fama’s early work, there have been countless other empirical studies published that looked for patterns in stock prices and markets. One might think that if stock prices are essentially unpredictable over short timeframes then they are even more unpredictable over longer ones. However, this is not the case. Indeed, it was Fama himself who in 1977 showed that the short-term interest rate could be used to forecast the longer term return on the stock market.
If prices follow a random walk, then their variance (the square of the standard deviation or volatility) over two year periods should be twice the variance over one year and so forth. In fact, for neither stocks nor bonds is this the case. However, unlike short-term returns which Fama had shown exhibit slight momentum tendencies, longer-term returns are mean reverting (variance over two years is less than variance over one year).
Fama is now a consultant to Dimensional Fund Advisors, a firm that sells so-called ‘Smart Beta’ funds that seek to take advantage of longer-term patterns such as low price-to-book companies outperforming high price-to book companies.
Mastering the short term is Jim Simons and the firm he founded, Renaissance Technologies. Renaissance houses a particularly big supercomputer, one which is able to delve far deeper into price movements than the devices that Fama used in the 1960s. The annualised returns over a number of years of his Renaissance Medallion Fund, now closed to outsiders, were spectacular.
Intuitively, it makes sense to me that the EMH is bunkum. Whether within markets or outside them, all events are a function, of what came before. Club hits ball, ball hits tree.
The key to successful active investing must therefore be to try to understand and exploit that function. That some are more able to do this than others surely makes sense. Like I said, investing is a game of skill not luck.
Published in Investment Letter, August 2019
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.