Eugene Fama and David Booth on the Birth of Modern Finance

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1:23Hello and welcome to another episode of the All Thoughts Podcast. I'm Traci Alloway. And I'm Joe Weisenthal. Joe, what's your favorite financial movie? I don't think I've ever asked you that question. Really? I mean, Trading Places. Oh, that's funny. That's mine, too. Yeah. And not only because it's funny, but because it led to a real life development, which I don't think a lot of people know, but the CFTC set up something called the Eddie Murphy Rule. I didn't know that. Because of Trading Places. I have no idea where you're going with this, by the way. And I think there has been an enforcement action.

1:55Well, what I was going to say is I think there is actually a lack of really good financial movies. Ah, okay. Here you go. Trading places aside. Yes, I would agree with it. Yeah. I know we have the big short and margin call was a very realistic description of what it's like to work at a bank. But I think we need more in our lives. And I think we also need financial movies that sort of delve into some of the theories of financial markets. And I get why we don't. those are really difficult to illustrate in a visual way, but I still want them. Me too. All right. Keep going, Tracy. Okay. Well, the good news is I just watched one that fits into that category.

2:37So there's a new documentary out called Tune Out the Noise, and it's all about the birth of modern finance. And it features an absolutely all-star cast of financial luminaries. So, So, you know, there are people like Merton Miller, Myron Scholes, Ken French, Markowitz, like the list goes on and on and on. And we're going to talk to two of them today. I'm really excited because I'm finally going to have a chance to ask, is it all priced in? Because this is my core belief about markets that it's like, nope, it's all priced in. And yet there appears to be a financial industry that must on some level be premised on the idea that it's not priced in.

3:20but I always assume that it's all priced in. And so maybe we'll finally get an answer to this question. I suspect the way you feel about the term premium is the way I feel about the efficient markets hypothesis. But let's get into it. We are speaking with David Booth, the founder and chairman of Dimensional Fund Advisors, and Professor Eugene Fama, who is, of course, a Nobel laureate. He is also a director at Dimensional, has had a long-running intellectual partnership with the firm. He's also sometimes called the father of modern finance. I could keep going on with the honorifics here, but you get the idea, I think.

3:55So, David and Gene, welcome to the show. Thank you. Well, thanks for having us and looking forward to it. I guess I'll start with the obvious question, but why a documentary movie about modern finance? It is, as I mentioned earlier, not exactly an easy story to tell visually. Well, it didn't start out to be a documentary. What happened was we started working with Errol Morris. You know, he won the Academy Award for his film Fog of War, a well-known documentarian. And we're talking to him about how we could use some of his expertise for our firm. And he got really into it. He had not much background in finance and just got so fired up, He wanted to make it his film rather than our film, which I found to be very exciting.

4:42That's cool. We've done an episode with Dimensional's co-CEO, Jared O 'Reilly. Why don't you talk to us a little bit about the partnership of the two of you for people who are not familiar, for people who are going to be watching the film for the first time. The two of you have been working together for literally decades and really two of the biggest names, truly, in the history of finance. And what is the sort of short version of this sort of intellectual partnership and how this firm Dimensional came about? Well, David was my research assistant 55 years ago, David. Yeah. Anyway, he worked with me for several years at the University of Chicago.

5:26And finally he came to me and said, I see what you do and I don't want to do it. So he said he wanted to go off and work in the financial industry. So I called Mac McQuown and got David a job that way with Wells Fargo. I guess it was at the time, David, right? Right. In 1971. Then eventually he went off on his own, found it dimensional and came back to me and asked me if I wanted to be somehow involved. We've been going at it ever since. Oh, yeah. This was in the movie. So I think Wells Fargo basically just decided to share some of its data and analysis with Vanguard, like at the very beginning of Jack Bogle's career.

6:07And everyone was sort of scratching their heads about why that happened. But do we have any sense of why that happened? Was there just a spirit of research or academic camaraderie that made private organizations share things with each other? Well, one of the things I've always admired about Gene is his research, which we use extensively. He's always insisted that his research be in the public domain. We're not in the business of creating black box that nobody understands. So it's so critically important to have an open-air philosophy about sharing research. And so, Wells got off to a slow start in some ways.

6:50But it was a fundamental question. Can you even track the performance of an index? And so Wells had done a lot of simulations and stuff. And when the group I was working on, Wells, got shut down, Mac just volunteered to Bogle to share all of his data with him. Gene, I'm curious from your perspective, how did this interest you as a intellectual field of study? And we'll get into some of the specific and sort of groundbreaking contributions to what many people now consider absolute truths to how the market worked. But some of your ideas, what attracted you to the study of markets and some of your early research?

7:33Well, I started on it in college, actually. I worked for a professor at Tufts that had a stock market forecasting service. And my job was to come up with new ways to beat the market. How'd that go? It didn't go very well in the following sense. He was a very good statistician, so he always kept a holdout sample. And my ideas always worked in sample, but they never worked out of sample. So that was my first lesson on what you can expect by trying to beat the market. And after that, I went off to Chicago, took my data with me from Tufts, and eventually wrote my thesis using that data, which was kind of the first or maybe one of the bigger trumpeting of fishing markets.

8:21The term wasn't even called that at the time, but eventually that term came around as well. One of the things that's interesting about that, observe, he did a study based on data collected by hand. And that was kind of the state of the world when I went to Chicago to do a research project. Frequently, he had to hand collect the data. You know, these new kids today wouldn't be aghast if they knew how we did things in the old days. Well, I remember in the old days of Bloomberg, we often inputted a lot of financial. If you're working in the global data department, you certainly inputted a lot of things by hand as well.

8:58This leads to a question I wanted to ask you. So a big chunk of the documentary is about all these different people who spent time at the University of Chicago. What was in the water at the university that attracted all these names that went on to do big things in finance? Well, Merton Miller was an important person. He was deeply interested in this stuff. And Harry Roberts was another important person who had written on something resembling what would be now called the fishing markets way back in the 50s. So he was very much interested in it. And they were kind of the two shining lights in this area.

9:38And plus, then there were a lot of PhD students, including me, who needed thesis topics. So having faculty interested in the topic was a good way of having research done by students in that topic, because that was the way to graduate. And at the time, I had two kids with another one on the way, so I was very, very keen on getting out quickly. Well, I would also add, you know, Jim Laurie. I mean, Jim and Larry Fisher, they persuaded Merrill Lynch to fund a study to collect a survivorship bias-free database, which enabled all these new young hotshots to do their research. And until that point, the data had never been collected correctly.

10:24And so he couldn't really do the research. When Larry Fisher started out to collect that data and put it together, a computer didn't exist that could handle it. But he said, well, it's going to come along by the time we finish this, there'll be a computer that could handle it. And he turned out to be right. Well, actually, this is exactly what I wanted to ask. And I think it sort of speaks to like a big theoretical question. Let's say part of good investing is having good data. Like if you have to collect the data by hand, you're already going to probably knock out 99.9 % of the people who have interest because I wouldn't do it because my wrists get really tired really fast and my handwriting is garbage.

11:09So I wouldn't even be able to read what I had written in the graph paper, etc. A lot of things that we take for granted about investing today, including measuring the performance of an index are things that literally take a few keystrokes or less on a Bloomberg terminal today. And I'm curious, like when you think about like generating superior returns over time, how much of an edge was that to just be willing to do the hard work of collecting data? Look, all these tests of market efficiency, which started in the 60s, you know, and have keep showing the same result in every sense, even though with increasing levels of sophistication of researchers and people having access to more and more data, better data, faster data, all of that still shows the same outcome of it doesn't look like trying to outguess the market as a winning game.

12:08So since we're on the subject of the efficient markets hypothesis, one of your former students who also went on to a great fame, Cliff Asnes, he published his own paper called The Less Efficient Markets Hypothesis, and it argues that markets are less efficient than they once were, in part because social media has basically turned us all into trend-following idiots, I guess. And this is something that I've occasionally wondered. If the efficient markets hypothesis is reliant on people making the right decisions with the information that they have or the data they have. What happens if we all get collectively more stupid?

12:47And I guess a different way of asking this is, has your view of the efficient markets hypothesis changed at all over time? No, it hasn't really changed. It's adaptive in the sense that I never said that the market was efficient for everybody. There are, for example, there's lots of evidence, for example, that company insiders have information that isn't already in prices. So as far as they're concerned, the stock of their company is not priced efficiently. That's one instance of it. But as far as professional managers are concerned, there is evidence that if you give them back all their fees and expenses, there are some who do have enough information to beat the market.

13:33But if you don't take out the fees and expenses, then the active managers look terrible relative to passive managers. So that's the kind of data and results that makes market efficiency look pretty good. But it's just a hypothesis. It's not a literal truth. It's just an approximation to the world. But it worked really well for almost everybody.

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14:53Giving teams across your organization an easy way to order from a huge variety of restaurants, all on one platform. All while consolidating your corporate food spend so you can control costs, streamline billing and payment, and simplify reporting. EasyCater, your business tool for food. To learn more, visit easycater.com slash podcast. So this gets to like a question that I've asked before, and I'm now thrilled to ask it to you, which is, why does the financial industry exist if markets are efficient? Because there are a lot of people that collect very big paychecks from some notion that they can deliver better returns.

15:38than someone else to their clients. If markets are efficient, at least to most people in the industry, why do we have this industry? Because there are people who think they can pick the managers that have special information. That's what keeps it going. That's what keeps the active managers going. It's individuals who don't think that passive investing is for them. And they invest, they go with the active people. So markets are always about competition. among different kinds of players. And then we see who comes out on top. Gene, how serious are you when you say stuff like there's no such thing as a bubble or that bubbles are only identifiable after they burst, so it's pointless to talk about them?

16:22Deadly serious. Deadly. Very serious? Right. Explain it more, because Joe and I have lots of episodes where we talk about either past bubbles or over-valuations. Yeah, so with 20-20 hindsight, side, it's always, you know, it's explained why prices went up and why they went down. But in my view, what a bubble means is price has gone up and you can predict when it's going to go down, when that whole phenomenon is going to, the whole price movement is going to go away. And that's what's proven really difficult to do. So lots of people use the word bubble very loosely. I canceled my subscription to The Economist because I'm using the word to describe - Us journalists are terrible about overusing bubble.

17:11I will cop to that on behalf of the entire profession. Right. So I need to know what the definition is before I can respond to it. And in that case, that's much more difficult. Most people aren't willing to do that. There are economists that are willing to do it, and I can deal with that. There has to be some predictability about when it's going to end. And that's what proven a man really difficult to establish. Right. It seems fairly clear that you could sort of sense like we're in some sort of mania and even knowing that fact and everyone agreeing on that fact. In fact, to try to establish that fact is often a good recipe for losing all your money if you're short it or losing all your clients if you're avoiding it.

17:53So I certainly take that point. Let me press further, though. So a lot of your research and this idea of market efficiency, but you've also worked on factors that seem over time historically to outperform. And so the idea of small companies outperforming big companies or value companies outperforming over time. Dimensional has funds that aren't just the pure market portfolio. Reconcile the existence of that with the idea of efficient market. Okay, that's a good question. So everybody has this confusion. The confusion is mixing together market efficiency and the dimensions of risk in portfolio selection.

18:39So going back all the way to Markowitz, we've long known, for example, that people don't like variance. They don't like uncertainty about future returns. And they're willing to pay something to avoid it. So that gave rise to the Schap-Lintner so-called capital asset pricing model in which sensitivity to the market was the measure of risk. So basically, it's a confusion of prices being reflecting value and the story about what are the dimensions of risk in the market. So that's a confusion that almost everybody seems to have. So a first market doesn't say there aren't risk premiums in the market.

19:21Does not say that at all. One way to think about it is, you know, define the market to be all the stocks and bonds that are out there. Most of us believe stocks over the long haul have a higher return than bonds. But few people invest all their money in stocks. It doesn't mean stocks are inefficient and efficiently priced. And just those are the market prices. And you look at different combinations of the two and they provide different distributions of outcomes. and just find that distribution that works best for you. So a big chunk of the documentary is about the birth of passive investing and its connection with the efficient markets hypothesis.

20:03What's been the impact of the growth of passive investing on the market? Because we often hear that, you know, markets are reflexive. Moves can end up impacting the market itself. And David, I think you yourself have argued that one of passive investing's biggest flaws is still very much alive, the index effect where stock prices go up a lot when a company is added to an index, even though everyone in theory should know that this is going to happen and so it should already be priced in. How has passive actually changed the market? Well, that's an interesting question. First off, the kind of the impact of an index adding a new name, you know, causing temporary prices to go up.

20:45That's a temporary effect. It doesn't really impact the long-term investor very much. One question that comes up a lot is, you know, if everybody indexed, then there would be no price discovery and wouldn't markets become inefficient? You know, that's kind of... And my answer to that is, well, let's take a look at the behavior of the market over the last 20 years. There's been an incredible movement to indexing over that time period. And yet there's been an incredible increase in trading volume. You know, I think of price discovery as being related to trading volume. So just because there's a big movement to indexing doesn't mean trading volume will decline.

21:28What's happened, unfortunately, is it turns out, like a lot of things that can be used for good, they can also be used for bad. And, you know, index funds are the ideal market timing vehicle. I'll buy this healthcare index fund and sell my technology fund or whatever it is. And I think that's really kind of what happened in the marketplace is it's kind of to an individual, instead of individual stock selection, it's kind of like a big gambling casino where you have a lot of different ways you can make your bets. So it doesn't look like in terms of the basic notion of market efficiency, it doesn't appear to have had much impact on that.

22:09So let me just take a little different direction. People worry that if everybody goes passive, how will prices get formed? And that's a legitimate concern. But then the issue is, who drops out? Who doesn't go active anymore? If it's bad active managers, people who have no special information, if they drop out, then you need fewer good active people to keep prices in line. So it depends on who drops out. as to whether it has any effect at all on market efficiency. And we haven't been able to discern anything like that in the behavior of prices, but that is the question. Since we're on the topic of indexing, you know, the market nowadays, as you mentioned, is basically defined by benchmark indexes, things like the S &P 500 or the MSCI World Index.

23:02And the benchmark index providers will often say that they're just holding up a mirror to the market as it exists. They're neutral. But it seems kind of obvious to me that their decisions do impact the market and some of those decisions can be subjective, you know, when it comes to measuring things like liquidity or how developed a particular bond market is or whatever. Are we just outsourcing investment decisions to index providers? You have to choose the one you want. So my own taste runs in the direction of a total market index being a good choice for almost everybody. So I don't go for the subset things, the 30 Dow Jones.

23:48That was always kind of dumb. But even the S &P 500, that's only 500. There's a lot more stocks out there than that. Let me just recoil against the term passive. You know, in my view, there's no such thing as passive management. And you're touching on something right there. You know, the different index providers and how they do it, and they all do it differently and so forth. And, you know, Standard & Poor's, when it wants to add stock to its S &P 500, you know, the investment committee sits around and talks about, you know, what do you like? You know, it's the S &P 500 is 500 of the largest companies, but it's not the 500 largest companies.

24:31And there's quite a bit of subjective judgment goes into deciding what stock goes into the index, which if you're going to an index fund because you don't like stock selection, that's not the kind of activity you want to see. I want to go back to this idea of even if markets are efficient, there still are risk premia and certain asset classes are expected to go up more than others due to people's wanting to avoid drawdowns, etc. You know, like I don't make many active decisions. I'm like a good like I follow what I read in the news and I like have some stocks and you know, probably have some treasuries and some fund or something like that.

25:12And I don't like pay attention to it much. Looking back, though, at historical trends in portfolio construction, I sometimes wonder, why should anyone own bonds? Because you say hardly anyone just owns stocks, and that seems to be objectively true. But I wonder if, is there reason to question some of this dogma of why, if I'm not going to retire in 30 years, do I care about, I'm already diversifying over time because I make an allocation to my retirement funds with every paycheck. So I'm already getting time diversification. Are there fundamental questions in portfolio construction that you think need to be rethought?

25:53If over the next 30 years before I can retire, 25 years maybe, like if almost everyone thinks it's certain that stocks will outperform bonds, why am I holding bonds? That's nuts. if almost everybody thinks that's true, but it's not true. Stocks don't get less risky in the long term. Risk accumulates. I don't understand that. I don't understand how... The risk is when you retire. When you retire, there will be a period when stocks have done particularly poorly and you will get hurt. That's always a possibility. It doesn't go away with time. So the presumption is what's incorrect. The risk is always there.

26:39You don't get rid of it. What do you think about the term smart beta? And is dimensional doing smart beta? Yeah, smart beta is a marketing term. Show me a dumb beta. I'm sure I could find some examples, but they certainly wouldn't have set out to create dumb beta. There's a lot of marketing. in the financial business, that's one of the big ones. But what does it mean to you? So when you hear that term, what is the person trying to sell to me? Well, you have to give me an example because I don't take it seriously, obviously. You can tell by me chuckling here. Well, I think it's Gene's research that he did with Ken French, his landmark 92 paper called Cross-Section of Expected Returns.

27:28Anyway, that kind of gave empirical support to the idea that there can be many dimensions of returns. So if you focus on a certain dimension, some people came up with the term smart beta. It's not smart. I mean, it's just a reflection of the research and the dimensions of returns, you know.

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