Eugene Fama Revisits Efficient Market Hypothesis

Published on May 29, 2009

The concept of the efficient market hypothesis is very simple: Prices reflect all available information, said Eugene Fama, Robert McCormick Distinguished Professor of Finance. “The empirical question is, what does that concept imply in terms of how prices behave?” Fama said.

Fama shared his views on his groundbreaking research, presented more than 40 years ago and further developed some 10 years later, during a special forum moderated by Edward Snyder, dean and George Pratt Shultz Professor of Economics, to close the 57th annual Management Conference at Gleacher Center on May 29.

The hypothesis became fully developed with the addition of the companion idea that researchers can’t test whether a market is efficient unless they determine what the market is trying to achieve, he said. “You have to tell me something about risk and something about expected returns, and then I can determine whether returns actually deviate from that,” Fama said. “Market efficiency cannot be tested independent of some model of equilibrium. This makes these two concepts sort of inseparable twins.”

A practical application of the theory suggests that passive portfolio managers, or those who hold index stocks reflecting the entire market or sectors of the market, get better returns than active portfolio managers, or those who deviate from the passive process, he said. “If some active manager is smart and is winning, there is some other active manager who is using the opposite weighting and is losing,” Fama said. “Active management, in total, has to be a zero sum game. After cost, it’s a big negative.”

Investors continue to ignore this principle because they want to believe “there is money left on the table for them,” he said. “That combined with the fact that people underestimate the range of outcomes you can get on a field of purely chance basis.”

For example, about 82 percent of the investments in the mutual fund industry are actively managed, Fama said. “These funds are all over the place, but when you put them together, you get the market portfolio,” he said. “They deliver returns that are almost perfectly correlated with the market. After cost, you lose about 1.2 percent a year, because that’s what people are charging you to do this.”

If the government had not intervened and instead allowed troubled banks to fail, their dissolution might have taken just a few days, Fama said. “When a bank fails, what it’s doing does not typically stop,” he said. “The stockholders and some of the bondholders get kicked out, and the rest gets sold off. The FDIC already has the power to step in, take the bank, and draw a line in the liability structure. Everything below the line is gone, and the bank then becomes viable.”

The beneficiaries of government intervention were the bondholders of these basically insolvent financial institutions, Fama said. “I laugh every time I hear somebody say the government injected equity capital into some financial institution,” he said. “The minute it goes in, that money goes to prop up the value of the bonds, not into equity capital. No private stockholders will come in. They can see what the problem is. They know they’re going to get less value than what they put in.”

                                                                                                                    -- Phil Rockrohr