March 25, 2025 • 55 mins
Jon Hartley and Eugene Fama discuss Gene’s career at the University of Chicago Booth School of Business since the 1960s and helping to start Dimensional Fund Advisers (DFA) in the 1980s, fat tails, the rise of modern portfolio theory, efficient markets versus behavioral finance, factor-based investing, the role of intermediaries, and whether asset prices are elastic versus inelastic with respect to demand.
Recorded on March 14, 2025.
ABOUT THE SPEAKERS:
Eugene F. Fama, 2013 Nobel laureate in economic sciences, is widely recognized as the "father of modern finance." His research is well-known in both the academic and investment communities. He is strongly identified with research on markets, particularly the efficient markets hypothesis. He focuses much of his research 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.
Fama is a prolific author, having written two books and published more than 100 articles in academic journals. He is among the most cited researchers in economics.
In addition to the Nobel Prize in Economic Sciences, Fama was the first elected fellow of the American Finance Association in 2001. He is also a fellow of the Econometric Society and the American Academy of Arts and Sciences. He was the first recipient of three major prizes in finance: the Deutsche Bank Prize in Financial Economics (2005), the Morgan Stanley American Finance Association Award for Excellence in Finance (2007), and the Onassis Prize in Finance (2009). Other awards include the 1982 Chaire Francqui (Belgian National Science Prize), the 2006 Nicholas Molodovsky Award from the CFA Institute recognizing his work in portfolio theory and asset pricing, and the 2007 Fred Arditti Innovation Award given by the Chicago Mercantile Exchange Center for Innovation. He was awarded doctor of law degrees by the University of Rochester and DePaul University, a doctor honoris causa by the Catholic University of Leuven, Belgium, and a doctor of science honoris causa by Tufts University.
Fama earned a bachelor's degree from Tufts University in 1960, followed by an MBA and PhD from the University of Chicago Graduate School of Business (now the Booth School) in 1964. He joined the GSB faculty in 1963.
Fama is a father of four and a grandfather of ten. He is an avid golfer, an opera buff, and a former windsurfer and tennis player. He is a member of Malden Catholic High School's athletic hall of fame.
Jon Hartley is currently a Policy Fellow at the Hoover Institution, an economics PhD Candidate at Stanford University, a Senior Fellow at the Foundation for Research on Equal Opportunity (FREOPP), a Senior Fellow at the Macdonald-Laurier Institute, and an Affiliated Scholar at the Mercatus Center. Jon also is the host of the Capitalism and Freedom in the 21st Century Podcast, an official podcast of the Hoover Institution, a member of the Canadian Group of Economists, and the chair of the Economic Club of Miami.
Jon has previously worked at Goldman Sachs Asset Management as a Fixed Income Portfolio Construction and Risk Management Associate and as a Quantitative Inves
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Transcript
Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
(00:00):
[MUSIC]
>> Jon Hartley (00:09):
This is the Capitalism and Freedom in the 21st Century podcast,
an official podcast of Hoover InstitutionEconomic Policy Working Group where we
talk about economics,markets and public policy.
I'm Jon Hartley, your host today.
My guest is Eugene Fonda, who is aprofessor of finance at the University of
Chicago at Booth School of Business,
is widely regarded as the father of modernfinance, as his research has really,
(00:30):
truly built the foundation of the field offinancial economics as we know it today,
for which he was awarded the Nobel Prizein economic sciences in 2013.
Welcome, Gene.
>> Eugene Fama (00:39):
Thank you, >> Jon Hartley
I want to first get into your early life.
You were born in Boston,you grew up in the Boston area.
All your grandparents were Italianimmigrants from Italy, as I understand it.
And my understanding is thatyou're actually named after one of
the Pope Eugenes.
(01:00):
You are an athletic all star atthe Malden Catholic High School,
you're in their athletic hall of fame.
And it's in the Boston area,that's Middlesex County.
You study Romance Languagesas an undergraduate at Tufts.
How did you get interested in finance anddecide to do an MBA and
(01:20):
PhD at University of Chicago and
arguably become the greatestfinancial economist ever?
Well, my initial intent was to be a sports coach and
a French teacher.
So I took Romance Languages there myfirst year, two years at Tufts, and
I was getting bored with it.
So I took an economics course andI loved it and the professors loved me.
(01:45):
They were reading my exams to the class,so I immediately switched into colleague.
And I was close as I couldin my last two years.
Then when it came time to, I said,
I think I want to go tograduate school and get a Ph.D.
And my professors, who were all Harvardgraduates, I said, I don't wanna go to
(02:06):
an economics department,I wanna go to a business school.
And they were all Harvard graduates.
And they said, well, don't go to Harvard,don't go to the University of Chicago.
They have more of an academicorientation there.
And so I applied, andI never heard back from them.
And March came along andnot having heard back, I called and
(02:27):
the Dean of Students answered the phone.
The student doesn't even have a phonenow because he's too important, but
answered the phone andtalked to me for a while.
He said, you know,I got some bad news for you, and
I don't have any recordof your application.
But he said,what kind of grades do you have?
And I said, well, basically all A's.
And he said, well,we just happened to have a scholarship for
(02:49):
somebody from Tufts.
Do you want it and that's how I endedup at the University of Chicago.
>> Jon Hartley (02:56):
Wow, that's amazing.
And I mean, in terms of yoursports interests, it's wonderful.
I know you play a lot of golf and
you're still playing a lotof golf over the years.
So it's great to seethat you maintain some of
that initial interest in sports as well.
You spent your entire careeras both a graduate student and
(03:16):
professor at the University of Chicago.
And you arrived there in the 1960s, and
there were a lot of other folkswho were there at that time.
I mean, it was truly, as I understand,a foundational period for
financial economics as a field.
There was solittle done at that point in time.
I mean, my sense is that,you know, Markowitz,
Harry Markowitz had just written downthe mean variance model in the 50s.
(03:40):
Things like the CAPM were sort ofjust being written down by folks
like Bill Sharp.
But at Chicago,you had folks like Martin Miller,
Harry Roberts, they're your advisors.
You had folks like Myron Scholz,who you advised, and
other folks like Dick Roll,many, many others who are really
foundational to financial economics anddeveloping the field as it was so early.
(04:06):
What was it like doing financialeconomics research at that time?
Obviously personal computers didn'treally even exist at that point in time.
How you would a young Gene Fama even dofinancial economics research in the 1960s?
I mean,what sorts of tools were you using and
what sorts of tools were being developed?
>> Eugene Fama (04:26):
Well, I got into it because Harry Roberts,
who was a statistics professorwho I really admired,
and Merton Miller,who was my main advisor.
The two of them who my advisors, they wereboth interested in the work that was going
on in describing price formation, tryingto say something intelligent about it.
(04:51):
And in there, people working in it.
There were some at MIT, some in Chicago.
They were kind of fumblingaround the edges.
They had no clear conception ofwhat they were trying to do.
So they were doing tests and saying theseare tests of market efficiencies, but
they're basically said efficiency applies,that prices are in walk.
But that, that was a very crude way of,of approaching stuff.
(05:15):
So basically what I did was I startedworking on that because I knew it was
a quick way to get a PhD becauseeverybody there was interested in it.
And I had two kids at the time andI had to get out quickly.
So I said, I started working, andthen I've been doing it, I guess more or
less ever since.
But basically what I added to it was astatement that what you're missing here is
(05:37):
that you have to have some statement aboutwhat equilibrium looks like in this world.
So what are expected returns that hadbeen totally left out of the picture?
That's what I call the jointhypothesis problem.
You have to say something about expectedreturns in order to say something
about market efficiency.
That really set the world into thinkingin that direction, and research exploded.
(06:02):
So I say to everybody, well,I was there at the right time.
That's what it comes down to.
Nothing had been done.
So everything you did was new,it was really very easy.
PhD students now have it very difficultbecause they have lots of stuff they have
to learn, and then they make a little playon the wrinkle, adding a wrinkle to it.
(06:22):
Whereas when we were doing it early on,it was like shining fish in a barrel,
everything had better.
>> Jon Hartley (06:28):
So, well,
now we're staying on the shouldersof giants like yourself.
And it's amazing as somebodywho's a young researcher.
Yeah, it's amazing to imagine just what itwould be like sitting in a room with any
of those people talking aboutfinancial economics and
what hadn't been written down yet.
(06:48):
It's really quite amazing.
And I know, you know, before I getinto sort of your body of work here,
I know just another amazing story,you know, University of Chicago,
that people, some people might know ormight not appreciate,
is that the University of Chicago BoothSchool of Business gets its namesake
(07:09):
ultimately from, in part, your thinking.
You know, two of your students,David Booth and Rex Sinquefield,
they were students of yours in the 1980s,and
they left to start one of the firstindex fund businesses and
brought you in as part of that effort.
(07:32):
And ultimately, because of that success,
David Booth made a very big contributionto the University of Chicago.
And hence,that's where it got its name from.
So the Booth School of Business name,in part is thanks to your ideas.
What was that like?
And could you explain to mea little bit about, you know,
(07:53):
what the early days of dimensional pointadvisor, DFA, which was founded by.
Field and did with your students.
What was that like?
And, and, you know,being part of it since.
>> Eugene Fama (08:07):
Well, Booth was my research assistant, my teaching assistant,
when at the same time thatRex was in the class, so
advanced class for PhD students andambitious MBA students.
And Rex took it all to Hyde,went off to American national instead of
really the first index slides based onwhat he learned in the course and David,
(08:32):
who was my research assistant and myteaching assistant, so he came to me and
finally after three years said,I see what you do for research.
I've been helping you do it,and I don't want to do it.
I want to go out and work.
So I called John Macquan at Wells Fargoand got him a job, and he went off
there and then 10 years later he calledme, he said he wanted to start a business.
(08:56):
And what he wanted to do was he had readall the recent work and there was a lot of
work at that time about how small stockstend to have high average returns.
And he said he wanted to start a smallstock fund because none existed for
institutional investors at that time.
They had stayed away from that,and he wanted to start one.
So that's how dimensional fundadvisors came about and he said,
(09:19):
I want you to be involved.
And I said, well, I don't target myresearch at commercial products and
he said, well, you do what you do.
We'll figure out if we can use any of it.
And that's basically the relationwe've had with them forever.
First me and then me andKen French after a while.
>> [COUGH]>> Jon Hartley: It's amazing.
I mean, it's amazing how applicablefinancial economics is in the real world.
(09:45):
And I remember you saying in the pastthat the future economics is
the most successful area of economics.
And I think if we're measuring success byapplication, I think that almost certainly
in the sort of magnitude of impact,I think that's almost certainly the case.
I can't imagine how finance thingslike factors, things like the cap and
(10:08):
someone who worked in finance,Goldman Sachs asset management for
five years, all these ideas like cap andbeta or market beta.
I mean, these things are just sofundamental to the practice of finance.
And what's amazing is, you know,you've done so much of, so
much work on this topic, andyou've been so early to so many topics.
(10:32):
I think my mind,
you're one of the few people I thinkthat would deserve two Nobel Prizes.
And just to list a few of these ideas likefat tails, were writing about fat tails,
the distribution of stock pricesin your PhD thesis in the 1960s,
the idea that stocks canhave extreme events.
(10:53):
And that was roughly aroundthe time when Black Swan author
Nassim Taylor was just born,you've written about event studies.
You're missing was the one who had that idea about the fat tails.
He said everything inthe world was fat tails, so.
>> Jon Hartley (11:11):
Wow, that's amazing I applied even earlier.
>> Eugene Fama (11:17):
I did not invent that concept, SOX.
I got it, I got it from him.
I applied it.
But it was, that was his idea,basically efficient markets,
I'll take credit forit, but not fat deals.
>> Jon Hartley (11:29):
We'll get to efficient markets in a minute here.
But you wanna think about event studiesand event studies just in general,
causal inference is swept economicsas a discipline since the 1990s.
But you were there in the 1960s with Fama,Fisher, Jensen and Roll,
(11:51):
1969, which sort of laid the groundworkfor doing event studies,
I think about the forwardpremium puzzle and carry trades.
In 1984, you wrote a paper aboutthe forward premium puzzle.
You know, the idea that, you know,
currencies aren't necessarily obeyingthe uncovered interest rate parity, where,
(12:12):
you know, the higher interest ratecurrencies are selling that they're not
actually selling off,as sort of theory would predict.
And then you've done also a lot of amazingwork in sort of the corporate finance,
organizational economics theory,the firm kind of area too and
a lot of amazing things like the stockmarket effects of buybacks, dividend
announcements agency problems theory,the firm, the idea that competitive
(12:35):
markets naturally sort of align withmanagerial and shareholder interests.
I'm just curious.
I mean, one, lots of these,all these greatest hits.
Many of these greatest hits are coveredin a book called the Fondal Portfolio,
which is a great collection of yourwork that's edited by John Cochrane and
Tobias Moskowitz as well.
But I'm curious, taking a step back,
(12:55):
how would you describethe overall theme of your work?
What in your mind tieseverything together?
Is it risk based asset pricing?
Diffusion of information, competition?
Dare I say efficient markets?
>> Eugene Fama (13:08):
Well, efficient markets is one but the logic underlying efficient
markets would have a lot to do withthe way, for example, Jensen and
I looked at and his markets more generallyin terms of organizational markets and
how they form and competition pushesthem in a particular direction.
So the idea of competition kind ofdetermining how economies work and
(13:33):
a lots of different dimensionsthat's basically the foundation
of efficient markets and the foundationof lots of other stuff that I've done.
But basically I think I had a knack ofgoing into areas where very little had
been done and coming up with simplestuff that people related to.
(13:54):
So I've always said that one of my besttalents is writing in a very simple way so
the maximum number ofpeople can understand it.
And I teach that to my students, someof them follow it, some of them don't.
But I still think it's a goodrule to go by in research.
(14:17):
But anyway,I think I was in part lucky and
in fact I had a pretty good nose forit, what good topics were.
>> Jon Hartley (14:24):
Amazing, to say the least.
So I want to start by getting intoefficient markets here and dive into it.
So there's this joint hypothesisproblem which you talked about in your
Nobel Prize lecture.
And that's been sort of a big theme of,I think, a lot of your work.
What led you to writeyour famous 1970 article,
(14:45):
Efficient Capital Markets, and sort ofwhat began this lifelong foray into
being sort of a defender of the efficientmarkets hypothesis that says that
stock markets are pricing informationquickly, was Mandelbrot at all
an influence here nd what was yourrelationship with Mandelbrot?
I'm curious.
>> Eugene Fama (15:05):
No, I had a good relationship with him.
He wasn't,he wasn't the motivator for that.
Basically, fat tails was hispassion throughout his whole life.
Fat tails of everything,those spillovers of the River Nile,
everything, rainfall,everything was fat tailed.
So, [LAUGH] And he was right,I think, pretty much true.
(15:26):
But that wasn't the motivation for
the research that I was doing onmarkets basically and how they work.
Economics of it, [COUGH] So
that's where the joyhypothesis problem came up.
And it's, [LAUGH] An unsolvabledilemma that you can't test market
efficiency outside the context of somemodel that tells you what equilibrium
(15:51):
expected returns look like.
So you need a model of market equilibriumin order to test whether enterprises
conform to that model sowhen you do the tests.
It's always a joint test.
You don't know what you're rejecting,whether you're rejecting a model of market
equilibrium or whether you'rerejecting market efficiency.
So that's the conundrumthat this insight poses.
(16:13):
But as a student of Harry Roberts,
what I learned was there'sno real truth out there.
You're basically just trying toimprove your description of the world.
There's nothing that'sreally truth top to bottom.
So you try to learn a little bitevery time we do something, but
don't expect that you learn everythingother care anywhere near 100%, right?
(16:35):
Somebody's gonna come along andimprove on what you do.
Maybe it's you, maybe it's somebody else,but somebody will do it.
>> Jon Hartley (16:44):
I guess my understanding is sort of that hypothesis problems,
it says that at some level,
efficient capital marks issomething that's difficult to test.
But a lot of your workthough is very empirical.
And so I'm curious, how in yourmind does you know your work on,
say, looking at dividend buybackannouncements and so forth?
(17:08):
I mean, and seeing how pricesrespond immediately to these things.
I mean, how do you thinka lot of your work advance,
your empirical work specifically kind ofadvance this idea of efficient markets?
I guess maybe you've justseen that many of these
events are sort of immediatelyincorporated into asset prices.
>> Eugene Fama (17:29):
Well, that part, farmer fisher,
Denson Roll was the first event study.
There have been thousandsof them since then, but
none of us had ever done another one.
So the original four neverdid another event study,
and now people do event studies.
(17:50):
They don't even give usa reference anymore.
It's so built into the literature.
It's in macroeconomics,basically, everywhere.
>> Jon Hartley (17:58):
Applied economics everywhere.
>> Eugene Fama (18:01):
For example, it's a fundamental way that the law people
try to establish precedence in law,so it's everywhere.
And->> Jon Hartley: As you say,
they're used in court cases,event studies.
I mean, it's amazing how influentialit is not just in academia and
(18:22):
academic research, butalso in the real world.
That's only half of it.
So the other half is you have to have somestatement about how prices get formed.
You need a model of market equilibrium.
And that's the other side of my researchon asset markets is trying to come up with
models of market equilibrium that helpus describe expected returns better.
(18:44):
Some of it worked well andsome of it I was really confident in and
it seemed to work in the US andaround the world.
Seems to have basically disappeared orgotten a lot weaker.
Maybe we killed it inthe process of developing it and
investors jumping onto it, but who knows.
(19:07):
But anyway, that was the otherside of the story that I've
worked on basically continuously.
>> Jon Hartley (19:15):
Good, totally, well, I wanna dive a little bit into, I guess,
we'll talk about factors in a second here,but I wanna talk a little bit just
about sort of efficient marketsversus behavioral finance.
And often I hear, when I've heard yourselfand Richard Thaler who sort of an emissary
that sort of behavioral finance schoolthat when you've been together on
(19:38):
panels that you generally agree onthe facts but disagree on interpretation.
And I think you maybe take more ofa risk-based or a rational lens
versus Thaler who takes more ofsay an irrational behavioral lens.
I'm curious what you think aboutthe legacy of efficient markets is and
what you think the legacy of,say, behavioral variance is.
(19:59):
I mean, there's been a massive rise inpassive investing over the decades,
which is a clear win forofficial markets obviously,
DFA, BlackRock, Vanguard,all part of that.
I mean, there's also thesesuper successful quantitative
hedge fund stories, Rentech,Shaw, some multimanager.
Then one could just argue that they'retaking advantage of information.
It's a rational story there as well, and
(20:20):
maybe only a small poolof investors can do that.
They provide liquidity, all these things.
Now, alpha is a zero sum game of beta,so they are doing active management that
that outperformance has to comeat the expense of some losers.
But I guess separately, there are someinvestors out there that I guess use and
hold up momentum and
some claim that there's momentum factors,those like your student, Mark Carhart.
(20:41):
And I think momentum isa pretty behavioral phenomenon.
I mean maybe some people are you.
There's momentum crashes,which are maybe compensated by risk.
But how do you think about things like,say, the 1990s tech boom or bitcoin?
I mean, are bubbles real?
I'm just curious how youthink about these things.
>> Eugene Fama (20:58):
Well, the way I think about them is you get to show me,
you can't just tell me thatthe market's inefficient.
So Taylor and I are great friends andI have been criticizing him for
many years saying basically whatyou call behavioral finance,
really just a criticismof efficient markets.
You don't have a theory of your own.
(21:19):
It's just a criticism.
So I think you're just a branchof efficient markets, Julie,
you're afraid to call yourself that.
>> [LAUGH]>> Eugene Fama: So
that he doesn't reallytake to that very well.
But [LAUGH] the challenge comes,you can see Bob Schiller,
who I admire a lot, andhe basically came up with a fundamental
(21:43):
insight that said pricesare much more variable than
you can explain if expectedreturns are constant.
So you have to have a lot of variationin expected returns to explain
the variation in stock returns.
Okay, that's fine, but then you haveto tell me that something in there is
(22:03):
irrational, either the variationof expected returns or
the deviation of returnsfrom expected returns.
And they haven't got that far andnot got much far.
So again, basically, it's all justa criticism of efficient markets.
And okay, fine, you're a subbranchof efficient markets then.
>> Jon Hartley (22:25):
Yeah, I mean, and
what you're referring to is RobertSchiller's observation that stock prices
are much more volatile than the presentdiscounted value exposed dividends.
If you were to look back over the many,many decades or over the centuries and
you were to take the future dividendswith the benefit of hindsight and
(22:47):
to discount them back using a discountrates would from that time.
Why is that value more constant thanthe actual stock prices themselves?
And maybe it's somethingthat you're using the wrong
discount rate, I guess, is->> Eugene Fama: The discount rates
are varying through time.
Exactly.
>> Eugene Fama (23:07):
That's almost a tautology.
You're saying, okay,that will do it, that's true.
But then have you got a story aboutwhat makes discount rates expected
returns rational or irrational.
And that's something about, well,
what are the limits ofa rational model of equilibrium?
And that one still is waiting out.
(23:27):
We're still waiting forthat one to get solved.
Either on the efficient market side orthe inefficient market side,
nobody's coming up with that,a really convincing argument there.
>> Jon Hartley (23:41):
How do you think about these things, I guess,
the 1990s tech boom or Bitcoin?
I mean, these things are extremely->> Eugene Fama: I
have a problem with Bitcoin.
I have a real problem there.
But what's your problem with Bitcoin?
>> Eugene Fama (23:59):
Well, Bitcoin Is not a credible medium of exchange.
My learning of macro of monetary economicsbasically said, if you're going to be
the medium of exchange, you can'thave a highly variable real value.
And Bitcoin's real valueis highly variable.
So think of it as businesses don't want todo business in terms of a unit of account
(24:21):
or a currency that's so highly variableit itself can knock them out of business.
Don't want to do that.
So you don't expect that a, a medium ofexchange that's highly variable in terms
of its real value, will survive.
That's just classic monetary theory.
So that's why bitcoin gives me a problem.
(24:42):
So I'm basically hoping it'll crash,that it will be a bubble.
But the problem with other bubblesis they turn out not to be.
You have to have a somewhat strangedefinition of a bubble to identify them.
So, for example, stock prices weresupposedly to have been a bubble.
And then it turns out they ended up,
(25:03):
they eventually went higher than they didwhen they were called, when it was called.
Who was the Fed governor?
The Fed guy at the time thatsaid they were a bumble anyway.
But it turned out to beprices did go down, but
then they went up much morethan they had gone down.
So at that point that's just a bundle.
It's just the random variation in prices.
>> Jon Hartley (25:27):
It's so interesting because,
I think 10 years ago there wasa lot of promises that that Bitcoin
was going to become moreof a medium of exchange,
that people would be using it to makepayments regularly in the real economy.
And that I think prettyobviously has not happened yet.
So it, I think in some weird way it's anasset that doesn't have any cash flows and
(25:51):
is just, you know, like in a sensea purely speculative asset where,
you know, it's only sort of worth whatother people believe it to be worth.
And obviously that can generate a lot ofvolatility if people's thoughts change.
But it's interesting that all these folks,you know,
some folks have said that it'san inflation sort of hedge.
(26:14):
And I don't think that's clear eitherbecause in fact it doesn't seem to
respond to bad.
>> Eugene Fama (26:19):
Can't be an inflation hitch.
Can't be an inflationbecause variance is too high.
Inflation has very low variance.
>> Jon Hartley (26:26):
Exactly.
So even when you geta negative inflation print,
it's not like bitcoinrallies in response to that.
But it seems to be very correlatedwith risk assets and stocks.
So it's almost like thispure risk asset in a sense.
So it's becoming something like that,based on this kind of idea that other
(26:46):
people will evaluate atsomething in the future.
All of crypto I think is interesting or
unique in this respect, andwe'll see where it all goes.
But particularly, interesting same thingI think with other bubbles where there's,
(27:08):
I think, often something orwhat people would call bubbles.
You often see either massive technologicaladvances that don't pan out or
you know, cases of fraud orother things like that.
I guess to be a bubble, you know,
you need a big, I guess contractionright after some big run up.
And so,I guess you think the 90s tech boom,
(27:30):
what happened there, a lot of projects.
>> Eugene Fama (27:34):
They were going to contend that this wasn't a bubble in the sense
that enough companies survived that andgot so extraordinarily big that that was
a good investment, butyou just couldn't pick the winners.
That was the only problem.
But the activity itself, the idea thatsomebody was going to emerge from that
time that would have a very highvaluation, that turned out to be true.
>> Jon Hartley (27:57):
We now have the Mag 7 stocks or the main stocks, Facebook,
Amazon and.
Google and all these companies.
It came out of that era,I guess, not Facebook,
but Amazon, Google came out of that era.
I guess sort of the next questionreally is getting into factors.
And so I'm curious what you thinkabout the so called factor zoo for
(28:21):
one, 10 years ago,finance researchers spent tons of
time researching assetpricing factors like size,
value, the market factor,some interesting momentum.
Obviously, the fama French Factorsfrom your 1993 paper, Size,
Value in the market.
Now there's I think a lot of questionsabout this empirical asset pricing.
(28:45):
It's much harder to publish I thinkpapers about factors and I think there's
questions about the persistence offactors after they're published.
Size factors haven't workedas well in recent decades.
The same with value.
I think this has created a lot ofchallenges for value based managers,
I think and there's some questions aboutsort of replicability or maybe if,
(29:08):
if a factor is publishedit gets arbitraged away.
I'm curious,what do you think about that and
just the legacy of I guess the famaFrench factors from your 1993 paper.
You have a more recent paper thatyou wrote in the 2010s that offers
five factors.
I'm curious what you thinkabout this concept of
(29:28):
factors to describethe behavior of stock prices.
>> Eugene Fama (29:33):
When French and I got into this, basically we said from the beginning
that we have to look andmake sure they're robust.
Did you see them not only in the US fora particular period, did you see them in
the US for periods outside the periodthat you use to identify them?
And then, you look around the world andsee if you see them other markers.
(29:55):
And that was the approachwe always followed.
So first we would expand the datain the US and then we would look
outside the US and we only wouldkind of concentrate something and
see it was a real factor ifit survived all those tests.
And that was fine.
But we also said, you know,that once you get past the market factor,
(30:18):
these specialized, more specializedfactors have to have something else in
them that causes people to be afraid ofthem and to let move in that direction.
And if people only are afraid of them,they can kill them.
They can kill these expected returnsassociated with these factors.
So we said that fromthe very beginning and
there's some chance thatthat's what actually happened.
(30:41):
So we found the size factor,the value factor, and
people weren't afraid of small stocks.
Turned out they weren'tafraid of value stocks.
So maybe they killed it.
I don't know.
I mean the problem is thatthese factors are buried in so
much variance you can't tellwhether they gone or not.
So it's going to take another 50 yearsto come up with the right answer and
(31:05):
I won't be alive then.
So we won't know.
>> Jon Hartley (31:09):
Well, you know, I know that.
What's amazing, I mean,just to think too, I mean we have,
I guess centuries of data now.
I mean some people have tried to takethe CRSP data and go back further.
I mean, were you a part of the foundthe creation of CRSP, the Center for
Research and Security Prices?
I know that that's I guess oneof the earlier sort of ideas or
(31:34):
efforts to compile a lot of asset data.
And that's been housed at the Universityof Chicago for a long period of time.
I mean to do early research,pre personal computers, I'm sure you
had to do a lot of work to even justget stock price data in those days.
People were looking to newspapers stillto look up stock price quotes often.
(31:58):
I'm, Curious,how did that evolution work in terms
of- Okay, I was there soI can tell you that one.
>> Eugene Fama (32:08):
[COUGH] Larry Fisher developed the NYSE tapes first
at the University of Chicago,but they weren't ready when I
was ready to write my thesis,they weren't even close to being ready.
[COUGH] So I had data that I hadcollected as an undergraduate at Tufts on
the 30 Dow Jones Industrials.
So that was the data that I used inmy thesis to develop [COUGH] both
(32:32):
the fat-tailed distribution stuff andthe efficient markets stuff.
So I didn't use the CRSPdata at all at that point.
And then the CRSP tapes came along andthe research in that area exploded.
But I'm not sure, was that yourfull question or did I miss some?
>> Jon Hartley (32:54):
No, that's it.
I mean, it's just, it's amazing.
I think people don't appreciate,I mean, now everyone has computers and
access to high-frequency data.
>> Eugene Fama (33:01):
Well, you're right, that's the other problem.
So when I was even withthe Dow Jones Industrials,
you're dealing witha machine that can test
problems with anyreasonable amounts of data.
You're sticking cards into thismachine to, to put it there.
(33:21):
And I used to go over in the middle ofthe night into the computation center and
do my work cuz there wasnobody there at that time.
Me and another guy in the physicsdepartments were the only ones there that
we could have access to this machinethat could do almost nothing [LAUGH] and
fill the whole room.
[LAUGH] But anyway,
(33:42):
that's what I use with these 30Dow Jones Industrials to do my thesis.
And so I work from it.
>> Jon Hartley (33:50):
That's amazing.
And yeah, just to think how just empiricalresearch has exploded since then.
And I guess I'm curious just to,I guess, get back to this question
of sort of factors and thinkingabout the structure of asset prices.
So one, I mean, there's been a massiveoutperformance in the market factor,
(34:15):
especially in US equity marketsin sort of the past decade or
since the financial crisis.
Whereas other advanced economy equitymarkets have been generally flat for
the past decade or so comparatively.
And maybe that's because GDP per capita
has also flatlined inthese sorts of countries.
(34:38):
I mean, do you have any thoughts on theequity risk premium or why it's been so
large compared to other countries?
I mean, there's some people out therewho say, well, quantitative easing
is a big part of the story andthe Fed wasn't doing that before 2008.
But what I would also say, wouldchallenge people when people say that
QE is responsible forthe massive run up in the stock market and
(35:02):
causing things like wealth inequality,so forth.
I mean, other central banks aroundthe world, the ECB, the Bank of Japan,
they were doing just as much quantitativeeasing as a fraction of GDP as
the Federal Reserve.
So I don't really think thatthe story is QE either.
I mean, the Fed buys a bond andalso issues reserves, and
(35:23):
maybe it's just sort ofa wash as a result of that.
But I'm curious, this massiveoutperformance of the US equities,
is that really a growthstory in your mind or
do you have any other thoughts->> Eugene Fama: I think it's just a growth
story, right, the fact that the US won onthe growth story in that period of time.
(35:44):
Europe that had been doing very well,Japan that had been doing very well,
didn't do sowell in that period economically.
So stock returns are the basically highly
leveraged claim onthe output of the country.
That's the explanation as far asI'm concerned, as far as I know.
It's just amazing to think, I mean, the idea that there would
(36:08):
be so much divergence between the US andother advanced economy countries.
I mean economists, macroeconomists fora long time talked about
divergence in general,which is really richer countries,
advanced economy countries getting richerwhile poor countries that presumably
(36:28):
could import the same technology andthe same ideas weren't catching up.
And there's some degree ofevidence that there's been
a convergence across all countries in,say, the 90s and 2000s.
I think since COVID,growth rates have gone back a bit.
But I think there's this kind of newtype of divergence that we're seeing,
(36:49):
which is just there's the US and everybodyelse and all the other countries.
And I think a lot of that might haveto do with technology, why most of
the largest technology companies inthe world are all based in the US.
And there's some story there,maybe it's a long run institution story,
that the US always been a verygood place to do business or
(37:10):
that these entrepreneurs came a longtime ago and sourced at the seed and
now all the top talent from aroundthe world wants to come to the US.
I mean, do you have any sort of macrothoughts on why the US has kinda won
this race, if you will?
>> Eugene Fama (37:25):
Well, that's a good one.
We've imported lots of high-end peoplein the tech industries that have been
instrumental in developing all these firmsthat have become massively profitable.
I don't know if you have togo any further than that.
So the talent wants to come here.
If we can keep it that way,we'll be happy.
>> Jon Hartley (37:47):
Yeah, I want to talk about some newer theories that I think try and
challenge efficient markets a little bit.
And it's interesting because we'retalking a lot about the 1960s and
what the prevailing sort of theories wereabout what moved asset prices prior to
(38:08):
the advent of modern finance, which is,you've been a central part of developing.
A lot of that has to do withthe role of information,
expected future dividends,expected returns.
And obviously equilibrium, no arbitrage,
(38:29):
all these things playinga big role in that.
But what's interestingis prior to the 1960s,
my understanding is that therewas a big emphasis on supply and
demand curves kind ofdetermining stock prices.
And what's interesting is I think someof those ideas have come back, and
(38:51):
there's a big debate right now aboutthe slope of the demand curve for stocks.
And of course, if markets wereperfectly informationally efficient,
I think the demand curve forstocks is perfectly elastic or
the demand curve isessentially totally horizontal.
>> Eugene Fama (39:07):
I don't so.
>> Jon Hartley (39:09):
You don't think so?
>> Eugene Fama (39:10):
No, of course not.
[LAUGH] Stock market is nodifferent from any other market.
If resources pour into it andpush prices up,
expected returns are gonna go downrather than other forms of investment.
So it can't be perfectly flat.
(39:31):
It's part of the overall, thatthe wealth in the world is limited, and
if more of it goes intoone asset than another,
that asset's price gets bid up andits expected return goes down.
So it can't be perfectly horizontal,not at the level of the entire market.
>> Jon Hartley (39:48):
I mean, well, it's interesting because I think behavioral
finance researchers, forexample, like Andre Shleifer,
he wrote a famous paper inthe 1980s that Titled yet
does the demand for stock slope down?
And, you know, that is what happensif there's, you know, some flow, some
(40:09):
exogenous flow into the stock market from,say, you know, a big index rebalance,
like, you know, the Russell 2000,it reconstitutes once a year.
And he looked at these index adjustment orindex reconstitutions,
like the Russell 2000 ads,takes out companies that have
(40:29):
changed in their size over the year andthey add a new one.
They do it on a certain date.
And that causes lots of flows from indexfunds in and out of certain stocks.
And, you know, you looked at thesestocks and argued, you know,
there's a reaction in stock pricesin that clearly quantities matter.
And then he concludes that the demandcurve for for stock prices,
(40:53):
do slope down, but just a bit,these demand curves are still elastic.
And we'll talk aboutwhat that kind of means.
But in part what it means is that aelastic means that, you know, a $1 billion
flow would lead to a less than $1 billionchange in, say, the market cap of stocks.
And I'm curious what you think about someof this even newer research on quantities,
(41:17):
like, for example, you know, this newarea called demand based asset pricing.
A lot of it's led by Ralph Koijen, who'sa finance colleague of yours at Booth,
part of his research agenda, he also hasthis paper with Xavier Gabaix that's
titled the Inelastic Markets Hypothesis.
And we've spent some timetalking about this paper before.
And they essentially claimthat the demand curves for
(41:39):
stocks are even more downward sloping,that they're very downward sloping.
And they claim that a $1billion inflow into the stock
market will cause a $5 billionappreciation approximately in market cap,
that stocks, at the macro level,are very responsive to flows.
(42:03):
And in part what they're trying to do issort of get at the origins of financial
fluctuation, what's causingfinancial fluctuations.
So what they claim is that it's reallyquantities, I think, that are really
driving fluctuations in asset prices,I think less than just information.
But I'm curious what you think about allthis research that claims that quantities
(42:25):
matter just a ton for stock, forstock market prices in determining them.
And I think at some level it's a bitof an affront to modern finance and
trying to go back to this era priorto modern finance, which obviously
plays a huge role on informationequilibrium, no arbitrage and so forth.
>> Eugene Fama (42:46):
I'M not that familiar with that research.
So I mean it comes down to are these,are these effect permanent?
Are these effects permanent or transitory?
So it's just a matter of tradingpushes' prices around temporarily.
That's, that's testable.
There should be some part ofthe variance of the prices
(43:08):
that's temporary that you can get out of,get around.
And there should betrading opportunities for
people who want to takeadvantage of this as well.
So it better be permanent,
otherwise it gives rise tolots of profit opportunities.
But I haven't followed it that closely,so I can't really comment on this.
>> Jon Hartley (43:28):
I do think that.
So my understanding is that the inelasticmarkets hypothesis does claim that these
effects are permanent.
That a $1 billion flow into say the equitymarket, say someone takes money out of
bonds or, or just they have a billiondollars in cash and in their bank account
and they, they put that billion dollars,you know, it could be a corporation or
have you, or investment manager,they put that money into the stock market.
(43:52):
They say that that's gonna lead toa $5 billion appreciation in the total
market cap.
>> Eugene Fama (44:01):
That's possible.
You know, when you said earlierthat the demand curves were flat,
we don't really know how elastic theyare at the aggregate level when you're
looking at the total shifts of totalwealth between different asset classes.
So we don't know what the effects are.
And I think that's whatRalph is working on there.
(44:22):
I'll have to go back andread that stuff a little more carefully.
It's not that easy for me, but I'll do it.
>> Jon Hartley (44:30):
Yeah, well, it's very interesting I think, and
they look at things likeflows into US equity markets.
And I think that there's, I think somechallenges too in terms of, you know.
Well, you know,what's driving those flows to begin with.
Right.Are they truly exogenous or is it just,
you know, this great US stockmarket run up that we've seen,
(44:50):
is that what's maybe causingthe quantity in the first place?
So I think it's a littlehard to disentangle the two.
And they use other strategies likegranular instrumental variables and
so forth.
I sort of have my own paper on this.
It's sort of a tongue in cheek titledthe Elastic Markets Hypothesis, is sort of
using country equity index additions anddeletions for identification.
(45:12):
So you have big index funds whichfrom time to time will have to
take their money out of a certaincountry or put money into a country,
say the MSCI Emerging Markets Index,say, promotes a country into its index.
And there's billions of dollars, orif not trillions of dollars that follow,
(45:35):
that kind of an index, andusing those for identification.
So I mean, we don't really find that,you know, that prices are all that
responsive to, to, to clients, but,but, but that there is some response.
And typically it's a bit moretransitory and temporary than,
than something that wouldbe a permanent change.
(45:57):
But what's interesting too is like,I think in the practitioner lens,
there's a lot of these rules of thumb,like the quadratic rule
when we think about things liketransaction costs, for example,
say you have some purchase of stocks,that it follows this three
(46:19):
halves function in terms ofthe market impact of a purchase.
When investment managers are trying tothink about what the impact of their own
trades are, they use this modelto sort of assume that going
into the market actually buyingsome stocks will have some effect.
They measure it, I think, prettyregularly using the sort of three-halves,
(46:43):
this kind of quadratic type rule.
But I think it's verymuch a transitory thing.
I don't know.Have you ever thought too much about say,
transaction costs and things of thatnature, as maybe more of a practitioner?
>> Eugene Fama (46:54):
I know, for example, that at Dimensional they've always been very
concerned about the effectsof trading on prices,
especially when they werein a small stock business.
But they could never really findthat there were lots of strong
temporary effects.
In all the research that was done there,they never could find that.
(47:17):
I never delved into it very much.
They have a whole crew of PhDs thatdo this kind of stuff for them.
But I was pretty well convinced thatthey were finding that the prices were,
at least for individual stocks,were pretty elastic.
They weren't that responsive tomagnitudes of money going into them.
>> Jon Hartley (47:40):
Yeah, and I think that's right.
I think, I do think thatmarkets are pretty elastic and
there's lots of active managersthat are trying to look at moments
where things are, maybe there'sa bit of market impact from say,
some sort of a flow, ormaybe there's these things like the.
(48:01):
Lipper a fund data thattracks mutual fund flows and
this data comes out pretty regularly.
I know a good number of bond traderssort of follow these sorts of things or
think about like month end effects forexample,
like all the bond indices reconstituteat the last day of every month.
(48:22):
There's a paper I wrote with a co authoron how prices, how treasury typically
rally on the last day of the month justbecause there's all these newly issued
Treasuries that don't enter the big bondindices until the last day of the month.
It's the same thing with stocks.
And typically a lot of rebalancinghappens at the end of the quarter.
(48:46):
And so if there's big fund flows andmaybe there's some
empirical finding that there's a jumpin prices along those days but
typically, these things aren't thatlong lasting, they're temporary.
And so the extent that they exist,
sure demand curves slope downa little bit but not too much.
And I think I agree with you there ondemand curves being fairly elastic but
(49:12):
not perfectly elastic.
And two, I think it's possible thatefficiency is saying something really
different which is saying something moreabout how information gets incorporated
and that's, that's different from,from, from demand too in quantities.
I think those things are,are a little bit different.
>> Eugene Fama (49:34):
Miller always said, when information comes into the market,
they didn't even be any trading and
prices adjust just the bestbid ask prices adjust.
So it doesn't really take trading to do itturns out it does take some trading to,
to do it as it turns out.
But you know, the information effects andprice pressure effects because
(49:55):
relative demand shifts for differentasset classes are two different things.
These are those two different things,one's kind of a micro thing and
the other is a macro thing.
So the macro thing isI think with Ralph and
Gabe are Interested in andthat one is an open issue.
I think we don't reallyknow the answer there.
They think they have it.
(50:17):
They're sure to attract people that willtry to substantiate what they're claiming.
So we'll, we'll see about that one.
>> Jon Hartley (50:28):
And other folks that may find the contrary as well and
maybe that's really kind of the newefficient markets versus behavioral
finance kind of a debate going forward.
>> Eugene Fama (50:39):
That isn't though that's just relative demand.
Give me shifts in relative demand fordifferent asset classes.
You can have price effects.
How big they are is the issue.
They could be big, they could be small.
I really don't know the answer.
>> Jon Hartley (50:54):
That's a great point.
I'm curious, one last question, I guesson just intermediaries and intermediary.
Asset pricing has been I think a bignew kind of area of research or
renewed area research in the,I think years after the financial crisis.
A lot of great researchers and
potential economists I think haveturned their attention to this.
(51:18):
I think of folks like Daryl Duffy, ArvinChristian Murthy and at Bismuth Jordan and
many others who are particularlyinterested in the effects of thinking
about things like fire sales that we sawmaybe during the financial crisis and
who is the marginal investor?
Who is,who's really determining asset prices and
(51:41):
there's a whole, who's pricingon their kernel and so forth.
I'm curious what you think about that sortof strand of literature and how you think
about intermediaries and in your minddoes the marginal investor matter in
the determination of asset prices oris everyone the marginal investor?
(52:03):
I'm curious,how do you think about all that?
>> Eugene Fama (52:05):
I think everyone is a marginal investor.
I'm concerned because everybody is,
everybody's holding the stock is basicallydeciding instant by instant implicitly or
explicitly to continue holdingbased on the prices or any assets.
So everybody's a module investoras far as I'm concerned,
I don't really relate verywell to that literature.
>> Jon Hartley (52:28):
And even I guess a retail investor or so called passive investor,
you don't think that they'remaybe less attentive or, and
that that would really matter orI guess that's a different issue.
>> Eugene Fama (52:42):
We can't have 100% passive investing, that's for sure.
There has to be somebody out there that'sconcerned about the prices being right and
there's somebody who makesmoney based on doing that.
Otherwise you're not goingto get an efficient market.
You know, that's market can't be efficientfor everybody sufficient for me.
Maybe it's efficient for you but
there have to be someknowledgeable investors out there.
(53:05):
So for example, insiders tradingthe stocks of their company,
they have inside informationthat's been well established.
But otherwise, you know, then they'realso, I think now Ken French and
I have a paper on mutual fund investingwhere we try to identify how much
information there is out there thatthe mutual funds capitalize on.
(53:27):
If you give them back all the moneythat they spend, fees and expenses,
then you can see that thereare winners and there are losers and
they're that they deviate from what youwould expect by pure chance if none
of them had any special information.
And that, that's fine.
I mean, they're helping to makethe market more efficient.
But.
>> Jon Hartley (53:50):
And I think that's the kind of maybe the insider, but
I guess Grossman, Siglitz, and I guessthe idea is that there always is some
a bit of alpha out there andthat generates these,
there's always people seekingthis little bit of alpha and
that there always has to be a littlebit in order to make markets efficient.
>> Eugene Fama (54:11):
Right.
You know, the, the,the question always arises,
how much of that do youneed to make it work?
And the answer is, well, depends onhow many bad guys there are out there,
how many disinformedinvestors are out there,
because they're the onesyou have to offset.
So you need fewer active investors.
(54:32):
If you, if all the disinformed guysbecome passive investors, one guy,
one belligerent active investor mightbe enough if all the bad ones drop out.
But we'll never know.
>> Jon Hartley (54:48):
Well, Gene, this has been an amazing conversation,
I really wanna thank you for coming on.
It's been a real delight to talkabout your career and ideas and
really just this set of ideas that reallybegan at the University of Chicago,
which you largely led inestablishing modern finance.
Really want to thank you for coming on.
This has been a trulyamazing conversation.
>> Eugene Fama (55:10):
My pleasure.
>> Jon Hartley (55:11):
This is the Capitalism and Freedom in the 21st Century podcast,
an official podcast of the Hoover EconomicPolicy Working Group where we talk
about economics, markets andpolitics policy.
I'm Jon Hartley, your host,thanks so much for joining us.
[MUSIC]
>> Jon Hartley (00:09):
This is the Capitalism and Freedom in the 21st Century podcast,
an official podcast of Hoover InstitutionEconomic Policy Working Group where we
talk about economics,markets and public policy.
I'm Jon Hartley, your host today.
My guest is Eugene Fonda, who is aprofessor of finance at the University of
Chicago at Booth School of Business,
is widely regarded as the father of modernfinance, as his research has really,
(00:30):
truly built the foundation of the field offinancial economics as we know it today,
for which he was awarded the Nobel Prizein economic sciences in 2013.
Welcome, Gene.
>> Eugene Fama (00:39):
Thank you, >> Jon Hartley
I want to first get into your early life.
You were born in Boston,you grew up in the Boston area.
All your grandparents were Italianimmigrants from Italy, as I understand it.
And my understanding is thatyou're actually named after one of
the Pope Eugenes.
(01:00):
You are an athletic all star atthe Malden Catholic High School,
you're in their athletic hall of fame.
And it's in the Boston area,that's Middlesex County.
You study Romance Languagesas an undergraduate at Tufts.
How did you get interested in finance anddecide to do an MBA and
(01:20):
PhD at University of Chicago and
arguably become the greatestfinancial economist ever?
Well, my initial intent was to be a sports coach and
a French teacher.
So I took Romance Languages there myfirst year, two years at Tufts, and
I was getting bored with it.
So I took an economics course andI loved it and the professors loved me.
(01:45):
They were reading my exams to the class,so I immediately switched into colleague.
And I was close as I couldin my last two years.
Then when it came time to, I said,
I think I want to go tograduate school and get a Ph.D.
And my professors, who were all Harvardgraduates, I said, I don't wanna go to
(02:06):
an economics department,I wanna go to a business school.
And they were all Harvard graduates.
And they said, well, don't go to Harvard,don't go to the University of Chicago.
They have more of an academicorientation there.
And so I applied, andI never heard back from them.
And March came along andnot having heard back, I called and
(02:27):
the Dean of Students answered the phone.
The student doesn't even have a phonenow because he's too important, but
answered the phone andtalked to me for a while.
He said, you know,I got some bad news for you, and
I don't have any recordof your application.
But he said,what kind of grades do you have?
And I said, well, basically all A's.
And he said, well,we just happened to have a scholarship for
(02:49):
somebody from Tufts.
Do you want it and that's how I endedup at the University of Chicago.
>> Jon Hartley (02:56):
Wow, that's amazing.
And I mean, in terms of yoursports interests, it's wonderful.
I know you play a lot of golf and
you're still playing a lotof golf over the years.
So it's great to seethat you maintain some of
that initial interest in sports as well.
You spent your entire careeras both a graduate student and
(03:16):
professor at the University of Chicago.
And you arrived there in the 1960s, and
there were a lot of other folkswho were there at that time.
I mean, it was truly, as I understand,a foundational period for
financial economics as a field.
There was solittle done at that point in time.
I mean, my sense is that,you know, Markowitz,
Harry Markowitz had just written downthe mean variance model in the 50s.
(03:40):
Things like the CAPM were sort ofjust being written down by folks
like Bill Sharp.
But at Chicago,you had folks like Martin Miller,
Harry Roberts, they're your advisors.
You had folks like Myron Scholz,who you advised, and
other folks like Dick Roll,many, many others who are really
foundational to financial economics anddeveloping the field as it was so early.
(04:06):
What was it like doing financialeconomics research at that time?
Obviously personal computers didn'treally even exist at that point in time.
How you would a young Gene Fama even dofinancial economics research in the 1960s?
I mean,what sorts of tools were you using and
what sorts of tools were being developed?
>> Eugene Fama (04:26):
Well, I got into it because Harry Roberts,
who was a statistics professorwho I really admired,
and Merton Miller,who was my main advisor.
The two of them who my advisors, they wereboth interested in the work that was going
on in describing price formation, tryingto say something intelligent about it.
(04:51):
And in there, people working in it.
There were some at MIT, some in Chicago.
They were kind of fumblingaround the edges.
They had no clear conception ofwhat they were trying to do.
So they were doing tests and saying theseare tests of market efficiencies, but
they're basically said efficiency applies,that prices are in walk.
But that, that was a very crude way of,of approaching stuff.
(05:15):
So basically what I did was I startedworking on that because I knew it was
a quick way to get a PhD becauseeverybody there was interested in it.
And I had two kids at the time andI had to get out quickly.
So I said, I started working, andthen I've been doing it, I guess more or
less ever since.
But basically what I added to it was astatement that what you're missing here is
(05:37):
that you have to have some statement aboutwhat equilibrium looks like in this world.
So what are expected returns that hadbeen totally left out of the picture?
That's what I call the jointhypothesis problem.
You have to say something about expectedreturns in order to say something
about market efficiency.
That really set the world into thinkingin that direction, and research exploded.
(06:02):
So I say to everybody, well,I was there at the right time.
That's what it comes down to.
Nothing had been done.
So everything you did was new,it was really very easy.
PhD students now have it very difficultbecause they have lots of stuff they have
to learn, and then they make a little playon the wrinkle, adding a wrinkle to it.
(06:22):
Whereas when we were doing it early on,it was like shining fish in a barrel,
everything had better.
>> Jon Hartley (06:28):
So, well,
now we're staying on the shouldersof giants like yourself.
And it's amazing as somebodywho's a young researcher.
Yeah, it's amazing to imagine just what itwould be like sitting in a room with any
of those people talking aboutfinancial economics and
what hadn't been written down yet.
(06:48):
It's really quite amazing.
And I know, you know, before I getinto sort of your body of work here,
I know just another amazing story,you know, University of Chicago,
that people, some people might know ormight not appreciate,
is that the University of Chicago BoothSchool of Business gets its namesake
(07:09):
ultimately from, in part, your thinking.
You know, two of your students,David Booth and Rex Sinquefield,
they were students of yours in the 1980s,and
they left to start one of the firstindex fund businesses and
brought you in as part of that effort.
(07:32):
And ultimately, because of that success,
David Booth made a very big contributionto the University of Chicago.
And hence,that's where it got its name from.
So the Booth School of Business name,in part is thanks to your ideas.
What was that like?
And could you explain to mea little bit about, you know,
(07:53):
what the early days of dimensional pointadvisor, DFA, which was founded by.
Field and did with your students.
What was that like?
And, and, you know,being part of it since.
>> Eugene Fama (08:07):
Well, Booth was my research assistant, my teaching assistant,
when at the same time thatRex was in the class, so
advanced class for PhD students andambitious MBA students.
And Rex took it all to Hyde,went off to American national instead of
really the first index slides based onwhat he learned in the course and David,
(08:32):
who was my research assistant and myteaching assistant, so he came to me and
finally after three years said,I see what you do for research.
I've been helping you do it,and I don't want to do it.
I want to go out and work.
So I called John Macquan at Wells Fargoand got him a job, and he went off
there and then 10 years later he calledme, he said he wanted to start a business.
(08:56):
And what he wanted to do was he had readall the recent work and there was a lot of
work at that time about how small stockstend to have high average returns.
And he said he wanted to start a smallstock fund because none existed for
institutional investors at that time.
They had stayed away from that,and he wanted to start one.
So that's how dimensional fundadvisors came about and he said,
(09:19):
I want you to be involved.
And I said, well, I don't target myresearch at commercial products and
he said, well, you do what you do.
We'll figure out if we can use any of it.
And that's basically the relationwe've had with them forever.
First me and then me andKen French after a while.
>> [COUGH]>> Jon Hartley: It's amazing.
I mean, it's amazing how applicablefinancial economics is in the real world.
(09:45):
And I remember you saying in the pastthat the future economics is
the most successful area of economics.
And I think if we're measuring success byapplication, I think that almost certainly
in the sort of magnitude of impact,I think that's almost certainly the case.
I can't imagine how finance thingslike factors, things like the cap and
(10:08):
someone who worked in finance,Goldman Sachs asset management for
five years, all these ideas like cap andbeta or market beta.
I mean, these things are just sofundamental to the practice of finance.
And what's amazing is, you know,you've done so much of, so
much work on this topic, andyou've been so early to so many topics.
(10:32):
I think my mind,
you're one of the few people I thinkthat would deserve two Nobel Prizes.
And just to list a few of these ideas likefat tails, were writing about fat tails,
the distribution of stock pricesin your PhD thesis in the 1960s,
the idea that stocks canhave extreme events.
(10:53):
And that was roughly aroundthe time when Black Swan author
Nassim Taylor was just born,you've written about event studies.
You're missing was the one who had that idea about the fat tails.
He said everything inthe world was fat tails, so.
>> Jon Hartley (11:11):
Wow, that's amazing I applied even earlier.
>> Eugene Fama (11:17):
I did not invent that concept, SOX.
I got it, I got it from him.
I applied it.
But it was, that was his idea,basically efficient markets,
I'll take credit forit, but not fat deals.
>> Jon Hartley (11:29):
We'll get to efficient markets in a minute here.
But you wanna think about event studiesand event studies just in general,
causal inference is swept economicsas a discipline since the 1990s.
But you were there in the 1960s with Fama,Fisher, Jensen and Roll,
(11:51):
1969, which sort of laid the groundworkfor doing event studies,
I think about the forwardpremium puzzle and carry trades.
In 1984, you wrote a paper aboutthe forward premium puzzle.
You know, the idea that, you know,
currencies aren't necessarily obeyingthe uncovered interest rate parity, where,
(12:12):
you know, the higher interest ratecurrencies are selling that they're not
actually selling off,as sort of theory would predict.
And then you've done also a lot of amazingwork in sort of the corporate finance,
organizational economics theory,the firm kind of area too and
a lot of amazing things like the stockmarket effects of buybacks, dividend
announcements agency problems theory,the firm, the idea that competitive
(12:35):
markets naturally sort of align withmanagerial and shareholder interests.
I'm just curious.
I mean, one, lots of these,all these greatest hits.
Many of these greatest hits are coveredin a book called the Fondal Portfolio,
which is a great collection of yourwork that's edited by John Cochrane and
Tobias Moskowitz as well.
But I'm curious, taking a step back,
(12:55):
how would you describethe overall theme of your work?
What in your mind tieseverything together?
Is it risk based asset pricing?
Diffusion of information, competition?
Dare I say efficient markets?
>> Eugene Fama (13:08):
Well, efficient markets is one but the logic underlying efficient
markets would have a lot to do withthe way, for example, Jensen and
I looked at and his markets more generallyin terms of organizational markets and
how they form and competition pushesthem in a particular direction.
So the idea of competition kind ofdetermining how economies work and
(13:33):
a lots of different dimensionsthat's basically the foundation
of efficient markets and the foundationof lots of other stuff that I've done.
But basically I think I had a knack ofgoing into areas where very little had
been done and coming up with simplestuff that people related to.
(13:54):
So I've always said that one of my besttalents is writing in a very simple way so
the maximum number ofpeople can understand it.
And I teach that to my students, someof them follow it, some of them don't.
But I still think it's a goodrule to go by in research.
(14:17):
But anyway,I think I was in part lucky and
in fact I had a pretty good nose forit, what good topics were.
>> Jon Hartley (14:24):
Amazing, to say the least.
So I want to start by getting intoefficient markets here and dive into it.
So there's this joint hypothesisproblem which you talked about in your
Nobel Prize lecture.
And that's been sort of a big theme of,I think, a lot of your work.
What led you to writeyour famous 1970 article,
(14:45):
Efficient Capital Markets, and sort ofwhat began this lifelong foray into
being sort of a defender of the efficientmarkets hypothesis that says that
stock markets are pricing informationquickly, was Mandelbrot at all
an influence here nd what was yourrelationship with Mandelbrot?
I'm curious.
>> Eugene Fama (15:05):
No, I had a good relationship with him.
He wasn't,he wasn't the motivator for that.
Basically, fat tails was hispassion throughout his whole life.
Fat tails of everything,those spillovers of the River Nile,
everything, rainfall,everything was fat tailed.
So, [LAUGH] And he was right,I think, pretty much true.
(15:26):
But that wasn't the motivation for
the research that I was doing onmarkets basically and how they work.
Economics of it, [COUGH] So
that's where the joyhypothesis problem came up.
And it's, [LAUGH] An unsolvabledilemma that you can't test market
efficiency outside the context of somemodel that tells you what equilibrium
(15:51):
expected returns look like.
So you need a model of market equilibriumin order to test whether enterprises
conform to that model sowhen you do the tests.
It's always a joint test.
You don't know what you're rejecting,whether you're rejecting a model of market
equilibrium or whether you'rerejecting market efficiency.
So that's the conundrumthat this insight poses.
(16:13):
But as a student of Harry Roberts,
what I learned was there'sno real truth out there.
You're basically just trying toimprove your description of the world.
There's nothing that'sreally truth top to bottom.
So you try to learn a little bitevery time we do something, but
don't expect that you learn everythingother care anywhere near 100%, right?
(16:35):
Somebody's gonna come along andimprove on what you do.
Maybe it's you, maybe it's somebody else,but somebody will do it.
>> Jon Hartley (16:44):
I guess my understanding is sort of that hypothesis problems,
it says that at some level,
efficient capital marks issomething that's difficult to test.
But a lot of your workthough is very empirical.
And so I'm curious, how in yourmind does you know your work on,
say, looking at dividend buybackannouncements and so forth?
(17:08):
I mean, and seeing how pricesrespond immediately to these things.
I mean, how do you thinka lot of your work advance,
your empirical work specifically kind ofadvance this idea of efficient markets?
I guess maybe you've justseen that many of these
events are sort of immediatelyincorporated into asset prices.
>> Eugene Fama (17:29):
Well, that part, farmer fisher,
Denson Roll was the first event study.
There have been thousandsof them since then, but
none of us had ever done another one.
So the original four neverdid another event study,
and now people do event studies.
(17:50):
They don't even give usa reference anymore.
It's so built into the literature.
It's in macroeconomics,basically, everywhere.
>> Jon Hartley (17:58):
Applied economics everywhere.
>> Eugene Fama (18:01):
For example, it's a fundamental way that the law people
try to establish precedence in law,so it's everywhere.
And->> Jon Hartley: As you say,
they're used in court cases,event studies.
I mean, it's amazing how influentialit is not just in academia and
(18:22):
academic research, butalso in the real world.
That's only half of it.
So the other half is you have to have somestatement about how prices get formed.
You need a model of market equilibrium.
And that's the other side of my researchon asset markets is trying to come up with
models of market equilibrium that helpus describe expected returns better.
(18:44):
Some of it worked well andsome of it I was really confident in and
it seemed to work in the US andaround the world.
Seems to have basically disappeared orgotten a lot weaker.
Maybe we killed it inthe process of developing it and
investors jumping onto it, but who knows.
(19:07):
But anyway, that was the otherside of the story that I've
worked on basically continuously.
>> Jon Hartley (19:15):
Good, totally, well, I wanna dive a little bit into, I guess,
we'll talk about factors in a second here,but I wanna talk a little bit just
about sort of efficient marketsversus behavioral finance.
And often I hear, when I've heard yourselfand Richard Thaler who sort of an emissary
that sort of behavioral finance schoolthat when you've been together on
(19:38):
panels that you generally agree onthe facts but disagree on interpretation.
And I think you maybe take more ofa risk-based or a rational lens
versus Thaler who takes more ofsay an irrational behavioral lens.
I'm curious what you think aboutthe legacy of efficient markets is and
what you think the legacy of,say, behavioral variance is.
(19:59):
I mean, there's been a massive rise inpassive investing over the decades,
which is a clear win forofficial markets obviously,
DFA, BlackRock, Vanguard,all part of that.
I mean, there's also thesesuper successful quantitative
hedge fund stories, Rentech,Shaw, some multimanager.
Then one could just argue that they'retaking advantage of information.
It's a rational story there as well, and
(20:20):
maybe only a small poolof investors can do that.
They provide liquidity, all these things.
Now, alpha is a zero sum game of beta,so they are doing active management that
that outperformance has to comeat the expense of some losers.
But I guess separately, there are someinvestors out there that I guess use and
hold up momentum and
some claim that there's momentum factors,those like your student, Mark Carhart.
(20:41):
And I think momentum isa pretty behavioral phenomenon.
I mean maybe some people are you.
There's momentum crashes,which are maybe compensated by risk.
But how do you think about things like,say, the 1990s tech boom or bitcoin?
I mean, are bubbles real?
I'm just curious how youthink about these things.
>> Eugene Fama (20:58):
Well, the way I think about them is you get to show me,
you can't just tell me thatthe market's inefficient.
So Taylor and I are great friends andI have been criticizing him for
many years saying basically whatyou call behavioral finance,
really just a criticismof efficient markets.
You don't have a theory of your own.
(21:19):
It's just a criticism.
So I think you're just a branchof efficient markets, Julie,
you're afraid to call yourself that.
>> [LAUGH]>> Eugene Fama: So
that he doesn't reallytake to that very well.
But [LAUGH] the challenge comes,you can see Bob Schiller,
who I admire a lot, andhe basically came up with a fundamental
(21:43):
insight that said pricesare much more variable than
you can explain if expectedreturns are constant.
So you have to have a lot of variationin expected returns to explain
the variation in stock returns.
Okay, that's fine, but then you haveto tell me that something in there is
(22:03):
irrational, either the variationof expected returns or
the deviation of returnsfrom expected returns.
And they haven't got that far andnot got much far.
So again, basically, it's all justa criticism of efficient markets.
And okay, fine, you're a subbranchof efficient markets then.
>> Jon Hartley (22:25):
Yeah, I mean, and
what you're referring to is RobertSchiller's observation that stock prices
are much more volatile than the presentdiscounted value exposed dividends.
If you were to look back over the many,many decades or over the centuries and
you were to take the future dividendswith the benefit of hindsight and
(22:47):
to discount them back using a discountrates would from that time.
Why is that value more constant thanthe actual stock prices themselves?
And maybe it's somethingthat you're using the wrong
discount rate, I guess, is->> Eugene Fama: The discount rates
are varying through time.
Exactly.
>> Eugene Fama (23:07):
That's almost a tautology.
You're saying, okay,that will do it, that's true.
But then have you got a story aboutwhat makes discount rates expected
returns rational or irrational.
And that's something about, well,
what are the limits ofa rational model of equilibrium?
And that one still is waiting out.
(23:27):
We're still waiting forthat one to get solved.
Either on the efficient market side orthe inefficient market side,
nobody's coming up with that,a really convincing argument there.
>> Jon Hartley (23:41):
How do you think about these things, I guess,
the 1990s tech boom or Bitcoin?
I mean, these things are extremely->> Eugene Fama: I
have a problem with Bitcoin.
I have a real problem there.
But what's your problem with Bitcoin?
>> Eugene Fama (23:59):
Well, Bitcoin Is not a credible medium of exchange.
My learning of macro of monetary economicsbasically said, if you're going to be
the medium of exchange, you can'thave a highly variable real value.
And Bitcoin's real valueis highly variable.
So think of it as businesses don't want todo business in terms of a unit of account
(24:21):
or a currency that's so highly variableit itself can knock them out of business.
Don't want to do that.
So you don't expect that a, a medium ofexchange that's highly variable in terms
of its real value, will survive.
That's just classic monetary theory.
So that's why bitcoin gives me a problem.
(24:42):
So I'm basically hoping it'll crash,that it will be a bubble.
But the problem with other bubblesis they turn out not to be.
You have to have a somewhat strangedefinition of a bubble to identify them.
So, for example, stock prices weresupposedly to have been a bubble.
And then it turns out they ended up,
(25:03):
they eventually went higher than they didwhen they were called, when it was called.
Who was the Fed governor?
The Fed guy at the time thatsaid they were a bumble anyway.
But it turned out to beprices did go down, but
then they went up much morethan they had gone down.
So at that point that's just a bundle.
It's just the random variation in prices.
>> Jon Hartley (25:27):
It's so interesting because,
I think 10 years ago there wasa lot of promises that that Bitcoin
was going to become moreof a medium of exchange,
that people would be using it to makepayments regularly in the real economy.
And that I think prettyobviously has not happened yet.
So it, I think in some weird way it's anasset that doesn't have any cash flows and
(25:51):
is just, you know, like in a sensea purely speculative asset where,
you know, it's only sort of worth whatother people believe it to be worth.
And obviously that can generate a lot ofvolatility if people's thoughts change.
But it's interesting that all these folks,you know,
some folks have said that it'san inflation sort of hedge.
(26:14):
And I don't think that's clear eitherbecause in fact it doesn't seem to
respond to bad.
>> Eugene Fama (26:19):
Can't be an inflation hitch.
Can't be an inflationbecause variance is too high.
Inflation has very low variance.
>> Jon Hartley (26:26):
Exactly.
So even when you geta negative inflation print,
it's not like bitcoinrallies in response to that.
But it seems to be very correlatedwith risk assets and stocks.
So it's almost like thispure risk asset in a sense.
So it's becoming something like that,based on this kind of idea that other
(26:46):
people will evaluate atsomething in the future.
All of crypto I think is interesting or
unique in this respect, andwe'll see where it all goes.
But particularly, interesting same thingI think with other bubbles where there's,
(27:08):
I think, often something orwhat people would call bubbles.
You often see either massive technologicaladvances that don't pan out or
you know, cases of fraud orother things like that.
I guess to be a bubble, you know,
you need a big, I guess contractionright after some big run up.
And so,I guess you think the 90s tech boom,
(27:30):
what happened there, a lot of projects.
>> Eugene Fama (27:34):
They were going to contend that this wasn't a bubble in the sense
that enough companies survived that andgot so extraordinarily big that that was
a good investment, butyou just couldn't pick the winners.
That was the only problem.
But the activity itself, the idea thatsomebody was going to emerge from that
time that would have a very highvaluation, that turned out to be true.
>> Jon Hartley (27:57):
We now have the Mag 7 stocks or the main stocks, Facebook,
Amazon and.
Google and all these companies.
It came out of that era,I guess, not Facebook,
but Amazon, Google came out of that era.
I guess sort of the next questionreally is getting into factors.
And so I'm curious what you thinkabout the so called factor zoo for
(28:21):
one, 10 years ago,finance researchers spent tons of
time researching assetpricing factors like size,
value, the market factor,some interesting momentum.
Obviously, the fama French Factorsfrom your 1993 paper, Size,
Value in the market.
Now there's I think a lot of questionsabout this empirical asset pricing.
(28:45):
It's much harder to publish I thinkpapers about factors and I think there's
questions about the persistence offactors after they're published.
Size factors haven't workedas well in recent decades.
The same with value.
I think this has created a lot ofchallenges for value based managers,
I think and there's some questions aboutsort of replicability or maybe if,
(29:08):
if a factor is publishedit gets arbitraged away.
I'm curious,what do you think about that and
just the legacy of I guess the famaFrench factors from your 1993 paper.
You have a more recent paper thatyou wrote in the 2010s that offers
five factors.
I'm curious what you thinkabout this concept of
(29:28):
factors to describethe behavior of stock prices.
>> Eugene Fama (29:33):
When French and I got into this, basically we said from the beginning
that we have to look andmake sure they're robust.
Did you see them not only in the US fora particular period, did you see them in
the US for periods outside the periodthat you use to identify them?
And then, you look around the world andsee if you see them other markers.
(29:55):
And that was the approachwe always followed.
So first we would expand the datain the US and then we would look
outside the US and we only wouldkind of concentrate something and
see it was a real factor ifit survived all those tests.
And that was fine.
But we also said, you know,that once you get past the market factor,
(30:18):
these specialized, more specializedfactors have to have something else in
them that causes people to be afraid ofthem and to let move in that direction.
And if people only are afraid of them,they can kill them.
They can kill these expected returnsassociated with these factors.
So we said that fromthe very beginning and
there's some chance thatthat's what actually happened.
(30:41):
So we found the size factor,the value factor, and
people weren't afraid of small stocks.
Turned out they weren'tafraid of value stocks.
So maybe they killed it.
I don't know.
I mean the problem is thatthese factors are buried in so
much variance you can't tellwhether they gone or not.
So it's going to take another 50 yearsto come up with the right answer and
(31:05):
I won't be alive then.
So we won't know.
>> Jon Hartley (31:09):
Well, you know, I know that.
What's amazing, I mean,just to think too, I mean we have,
I guess centuries of data now.
I mean some people have tried to takethe CRSP data and go back further.
I mean, were you a part of the foundthe creation of CRSP, the Center for
Research and Security Prices?
I know that that's I guess oneof the earlier sort of ideas or
(31:34):
efforts to compile a lot of asset data.
And that's been housed at the Universityof Chicago for a long period of time.
I mean to do early research,pre personal computers, I'm sure you
had to do a lot of work to even justget stock price data in those days.
People were looking to newspapers stillto look up stock price quotes often.
(31:58):
I'm, Curious,how did that evolution work in terms
of- Okay, I was there soI can tell you that one.
>> Eugene Fama (32:08):
[COUGH] Larry Fisher developed the NYSE tapes first
at the University of Chicago,but they weren't ready when I
was ready to write my thesis,they weren't even close to being ready.
[COUGH] So I had data that I hadcollected as an undergraduate at Tufts on
the 30 Dow Jones Industrials.
So that was the data that I used inmy thesis to develop [COUGH] both
(32:32):
the fat-tailed distribution stuff andthe efficient markets stuff.
So I didn't use the CRSPdata at all at that point.
And then the CRSP tapes came along andthe research in that area exploded.
But I'm not sure, was that yourfull question or did I miss some?
>> Jon Hartley (32:54):
No, that's it.
I mean, it's just, it's amazing.
I think people don't appreciate,I mean, now everyone has computers and
access to high-frequency data.
>> Eugene Fama (33:01):
Well, you're right, that's the other problem.
So when I was even withthe Dow Jones Industrials,
you're dealing witha machine that can test
problems with anyreasonable amounts of data.
You're sticking cards into thismachine to, to put it there.
(33:21):
And I used to go over in the middle ofthe night into the computation center and
do my work cuz there wasnobody there at that time.
Me and another guy in the physicsdepartments were the only ones there that
we could have access to this machinethat could do almost nothing [LAUGH] and
fill the whole room.
[LAUGH] But anyway,
(33:42):
that's what I use with these 30Dow Jones Industrials to do my thesis.
And so I work from it.
>> Jon Hartley (33:50):
That's amazing.
And yeah, just to think how just empiricalresearch has exploded since then.
And I guess I'm curious just to,I guess, get back to this question
of sort of factors and thinkingabout the structure of asset prices.
So one, I mean, there's been a massiveoutperformance in the market factor,
(34:15):
especially in US equity marketsin sort of the past decade or
since the financial crisis.
Whereas other advanced economy equitymarkets have been generally flat for
the past decade or so comparatively.
And maybe that's because GDP per capita
has also flatlined inthese sorts of countries.
(34:38):
I mean, do you have any thoughts on theequity risk premium or why it's been so
large compared to other countries?
I mean, there's some people out therewho say, well, quantitative easing
is a big part of the story andthe Fed wasn't doing that before 2008.
But what I would also say, wouldchallenge people when people say that
QE is responsible forthe massive run up in the stock market and
(35:02):
causing things like wealth inequality,so forth.
I mean, other central banks aroundthe world, the ECB, the Bank of Japan,
they were doing just as much quantitativeeasing as a fraction of GDP as
the Federal Reserve.
So I don't really think thatthe story is QE either.
I mean, the Fed buys a bond andalso issues reserves, and
(35:23):
maybe it's just sort ofa wash as a result of that.
But I'm curious, this massiveoutperformance of the US equities,
is that really a growthstory in your mind or
do you have any other thoughts->> Eugene Fama: I think it's just a growth
story, right, the fact that the US won onthe growth story in that period of time.
(35:44):
Europe that had been doing very well,Japan that had been doing very well,
didn't do sowell in that period economically.
So stock returns are the basically highly
leveraged claim onthe output of the country.
That's the explanation as far asI'm concerned, as far as I know.
It's just amazing to think, I mean, the idea that there would
(36:08):
be so much divergence between the US andother advanced economy countries.
I mean economists, macroeconomists fora long time talked about
divergence in general,which is really richer countries,
advanced economy countries getting richerwhile poor countries that presumably
(36:28):
could import the same technology andthe same ideas weren't catching up.
And there's some degree ofevidence that there's been
a convergence across all countries in,say, the 90s and 2000s.
I think since COVID,growth rates have gone back a bit.
But I think there's this kind of newtype of divergence that we're seeing,
(36:49):
which is just there's the US and everybodyelse and all the other countries.
And I think a lot of that might haveto do with technology, why most of
the largest technology companies inthe world are all based in the US.
And there's some story there,maybe it's a long run institution story,
that the US always been a verygood place to do business or
(37:10):
that these entrepreneurs came a longtime ago and sourced at the seed and
now all the top talent from aroundthe world wants to come to the US.
I mean, do you have any sort of macrothoughts on why the US has kinda won
this race, if you will?
>> Eugene Fama (37:25):
Well, that's a good one.
We've imported lots of high-end peoplein the tech industries that have been
instrumental in developing all these firmsthat have become massively profitable.
I don't know if you have togo any further than that.
So the talent wants to come here.
If we can keep it that way,we'll be happy.
>> Jon Hartley (37:47):
Yeah, I want to talk about some newer theories that I think try and
challenge efficient markets a little bit.
And it's interesting because we'retalking a lot about the 1960s and
what the prevailing sort of theories wereabout what moved asset prices prior to
(38:08):
the advent of modern finance, which is,you've been a central part of developing.
A lot of that has to do withthe role of information,
expected future dividends,expected returns.
And obviously equilibrium, no arbitrage,
(38:29):
all these things playinga big role in that.
But what's interestingis prior to the 1960s,
my understanding is that therewas a big emphasis on supply and
demand curves kind ofdetermining stock prices.
And what's interesting is I think someof those ideas have come back, and
(38:51):
there's a big debate right now aboutthe slope of the demand curve for stocks.
And of course, if markets wereperfectly informationally efficient,
I think the demand curve forstocks is perfectly elastic or
the demand curve isessentially totally horizontal.
>> Eugene Fama (39:07):
I don't so.
>> Jon Hartley (39:09):
You don't think so?
>> Eugene Fama (39:10):
No, of course not.
[LAUGH] Stock market is nodifferent from any other market.
If resources pour into it andpush prices up,
expected returns are gonna go downrather than other forms of investment.
So it can't be perfectly flat.
(39:31):
It's part of the overall, thatthe wealth in the world is limited, and
if more of it goes intoone asset than another,
that asset's price gets bid up andits expected return goes down.
So it can't be perfectly horizontal,not at the level of the entire market.
>> Jon Hartley (39:48):
I mean, well, it's interesting because I think behavioral
finance researchers, forexample, like Andre Shleifer,
he wrote a famous paper inthe 1980s that Titled yet
does the demand for stock slope down?
And, you know, that is what happensif there's, you know, some flow, some
(40:09):
exogenous flow into the stock market from,say, you know, a big index rebalance,
like, you know, the Russell 2000,it reconstitutes once a year.
And he looked at these index adjustment orindex reconstitutions,
like the Russell 2000 ads,takes out companies that have
(40:29):
changed in their size over the year andthey add a new one.
They do it on a certain date.
And that causes lots of flows from indexfunds in and out of certain stocks.
And, you know, you looked at thesestocks and argued, you know,
there's a reaction in stock pricesin that clearly quantities matter.
And then he concludes that the demandcurve for for stock prices,
(40:53):
do slope down, but just a bit,these demand curves are still elastic.
And we'll talk aboutwhat that kind of means.
But in part what it means is that aelastic means that, you know, a $1 billion
flow would lead to a less than $1 billionchange in, say, the market cap of stocks.
And I'm curious what you think about someof this even newer research on quantities,
(41:17):
like, for example, you know, this newarea called demand based asset pricing.
A lot of it's led by Ralph Koijen, who'sa finance colleague of yours at Booth,
part of his research agenda, he also hasthis paper with Xavier Gabaix that's
titled the Inelastic Markets Hypothesis.
And we've spent some timetalking about this paper before.
And they essentially claimthat the demand curves for
(41:39):
stocks are even more downward sloping,that they're very downward sloping.
And they claim that a $1billion inflow into the stock
market will cause a $5 billionappreciation approximately in market cap,
that stocks, at the macro level,are very responsive to flows.
(42:03):
And in part what they're trying to do issort of get at the origins of financial
fluctuation, what's causingfinancial fluctuations.
So what they claim is that it's reallyquantities, I think, that are really
driving fluctuations in asset prices,I think less than just information.
But I'm curious what you think about allthis research that claims that quantities
(42:25):
matter just a ton for stock, forstock market prices in determining them.
And I think at some level it's a bitof an affront to modern finance and
trying to go back to this era priorto modern finance, which obviously
plays a huge role on informationequilibrium, no arbitrage and so forth.
>> Eugene Fama (42:46):
I'M not that familiar with that research.
So I mean it comes down to are these,are these effect permanent?
Are these effects permanent or transitory?
So it's just a matter of tradingpushes' prices around temporarily.
That's, that's testable.
There should be some part ofthe variance of the prices
(43:08):
that's temporary that you can get out of,get around.
And there should betrading opportunities for
people who want to takeadvantage of this as well.
So it better be permanent,
otherwise it gives rise tolots of profit opportunities.
But I haven't followed it that closely,so I can't really comment on this.
>> Jon Hartley (43:28):
I do think that.
So my understanding is that the inelasticmarkets hypothesis does claim that these
effects are permanent.
That a $1 billion flow into say the equitymarket, say someone takes money out of
bonds or, or just they have a billiondollars in cash and in their bank account
and they, they put that billion dollars,you know, it could be a corporation or
have you, or investment manager,they put that money into the stock market.
(43:52):
They say that that's gonna lead toa $5 billion appreciation in the total
market cap.
>> Eugene Fama (44:01):
That's possible.
You know, when you said earlierthat the demand curves were flat,
we don't really know how elastic theyare at the aggregate level when you're
looking at the total shifts of totalwealth between different asset classes.
So we don't know what the effects are.
And I think that's whatRalph is working on there.
(44:22):
I'll have to go back andread that stuff a little more carefully.
It's not that easy for me, but I'll do it.
>> Jon Hartley (44:30):
Yeah, well, it's very interesting I think, and
they look at things likeflows into US equity markets.
And I think that there's, I think somechallenges too in terms of, you know.
Well, you know,what's driving those flows to begin with.
Right.Are they truly exogenous or is it just,
you know, this great US stockmarket run up that we've seen,
(44:50):
is that what's maybe causingthe quantity in the first place?
So I think it's a littlehard to disentangle the two.
And they use other strategies likegranular instrumental variables and
so forth.
I sort of have my own paper on this.
It's sort of a tongue in cheek titledthe Elastic Markets Hypothesis, is sort of
using country equity index additions anddeletions for identification.
(45:12):
So you have big index funds whichfrom time to time will have to
take their money out of a certaincountry or put money into a country,
say the MSCI Emerging Markets Index,say, promotes a country into its index.
And there's billions of dollars, orif not trillions of dollars that follow,
(45:35):
that kind of an index, andusing those for identification.
So I mean, we don't really find that,you know, that prices are all that
responsive to, to, to clients, but,but, but that there is some response.
And typically it's a bit moretransitory and temporary than,
than something that wouldbe a permanent change.
(45:57):
But what's interesting too is like,I think in the practitioner lens,
there's a lot of these rules of thumb,like the quadratic rule
when we think about things liketransaction costs, for example,
say you have some purchase of stocks,that it follows this three
(46:19):
halves function in terms ofthe market impact of a purchase.
When investment managers are trying tothink about what the impact of their own
trades are, they use this modelto sort of assume that going
into the market actually buyingsome stocks will have some effect.
They measure it, I think, prettyregularly using the sort of three-halves,
(46:43):
this kind of quadratic type rule.
But I think it's verymuch a transitory thing.
I don't know.Have you ever thought too much about say,
transaction costs and things of thatnature, as maybe more of a practitioner?
>> Eugene Fama (46:54):
I know, for example, that at Dimensional they've always been very
concerned about the effectsof trading on prices,
especially when they werein a small stock business.
But they could never really findthat there were lots of strong
temporary effects.
In all the research that was done there,they never could find that.
(47:17):
I never delved into it very much.
They have a whole crew of PhDs thatdo this kind of stuff for them.
But I was pretty well convinced thatthey were finding that the prices were,
at least for individual stocks,were pretty elastic.
They weren't that responsive tomagnitudes of money going into them.
>> Jon Hartley (47:40):
Yeah, and I think that's right.
I think, I do think thatmarkets are pretty elastic and
there's lots of active managersthat are trying to look at moments
where things are, maybe there'sa bit of market impact from say,
some sort of a flow, ormaybe there's these things like the.
(48:01):
Lipper a fund data thattracks mutual fund flows and
this data comes out pretty regularly.
I know a good number of bond traderssort of follow these sorts of things or
think about like month end effects forexample,
like all the bond indices reconstituteat the last day of every month.
(48:22):
There's a paper I wrote with a co authoron how prices, how treasury typically
rally on the last day of the month justbecause there's all these newly issued
Treasuries that don't enter the big bondindices until the last day of the month.
It's the same thing with stocks.
And typically a lot of rebalancinghappens at the end of the quarter.
(48:46):
And so if there's big fund flows andmaybe there's some
empirical finding that there's a jumpin prices along those days but
typically, these things aren't thatlong lasting, they're temporary.
And so the extent that they exist,
sure demand curves slope downa little bit but not too much.
And I think I agree with you there ondemand curves being fairly elastic but
(49:12):
not perfectly elastic.
And two, I think it's possible thatefficiency is saying something really
different which is saying something moreabout how information gets incorporated
and that's, that's different from,from, from demand too in quantities.
I think those things are,are a little bit different.
>> Eugene Fama (49:34):
Miller always said, when information comes into the market,
they didn't even be any trading and
prices adjust just the bestbid ask prices adjust.
So it doesn't really take trading to do itturns out it does take some trading to,
to do it as it turns out.
But you know, the information effects andprice pressure effects because
(49:55):
relative demand shifts for differentasset classes are two different things.
These are those two different things,one's kind of a micro thing and
the other is a macro thing.
So the macro thing isI think with Ralph and
Gabe are Interested in andthat one is an open issue.
I think we don't reallyknow the answer there.
They think they have it.
(50:17):
They're sure to attract people that willtry to substantiate what they're claiming.
So we'll, we'll see about that one.
>> Jon Hartley (50:28):
And other folks that may find the contrary as well and
maybe that's really kind of the newefficient markets versus behavioral
finance kind of a debate going forward.
>> Eugene Fama (50:39):
That isn't though that's just relative demand.
Give me shifts in relative demand fordifferent asset classes.
You can have price effects.
How big they are is the issue.
They could be big, they could be small.
I really don't know the answer.
>> Jon Hartley (50:54):
That's a great point.
I'm curious, one last question, I guesson just intermediaries and intermediary.
Asset pricing has been I think a bignew kind of area of research or
renewed area research in the,I think years after the financial crisis.
A lot of great researchers and
potential economists I think haveturned their attention to this.
(51:18):
I think of folks like Daryl Duffy, ArvinChristian Murthy and at Bismuth Jordan and
many others who are particularlyinterested in the effects of thinking
about things like fire sales that we sawmaybe during the financial crisis and
who is the marginal investor?
Who is,who's really determining asset prices and
(51:41):
there's a whole, who's pricingon their kernel and so forth.
I'm curious what you think about that sortof strand of literature and how you think
about intermediaries and in your minddoes the marginal investor matter in
the determination of asset prices oris everyone the marginal investor?
(52:03):
I'm curious,how do you think about all that?
>> Eugene Fama (52:05):
I think everyone is a marginal investor.
I'm concerned because everybody is,
everybody's holding the stock is basicallydeciding instant by instant implicitly or
explicitly to continue holdingbased on the prices or any assets.
So everybody's a module investoras far as I'm concerned,
I don't really relate verywell to that literature.
>> Jon Hartley (52:28):
And even I guess a retail investor or so called passive investor,
you don't think that they'remaybe less attentive or, and
that that would really matter orI guess that's a different issue.
>> Eugene Fama (52:42):
We can't have 100% passive investing, that's for sure.
There has to be somebody out there that'sconcerned about the prices being right and
there's somebody who makesmoney based on doing that.
Otherwise you're not goingto get an efficient market.
You know, that's market can't be efficientfor everybody sufficient for me.
Maybe it's efficient for you but
there have to be someknowledgeable investors out there.
(53:05):
So for example, insiders tradingthe stocks of their company,
they have inside informationthat's been well established.
But otherwise, you know, then they'realso, I think now Ken French and
I have a paper on mutual fund investingwhere we try to identify how much
information there is out there thatthe mutual funds capitalize on.
(53:27):
If you give them back all the moneythat they spend, fees and expenses,
then you can see that thereare winners and there are losers and
they're that they deviate from what youwould expect by pure chance if none
of them had any special information.
And that, that's fine.
I mean, they're helping to makethe market more efficient.
But.
>> Jon Hartley (53:50):
And I think that's the kind of maybe the insider, but
I guess Grossman, Siglitz, and I guessthe idea is that there always is some
a bit of alpha out there andthat generates these,
there's always people seekingthis little bit of alpha and
that there always has to be a littlebit in order to make markets efficient.
>> Eugene Fama (54:11):
Right.
You know, the, the,the question always arises,
how much of that do youneed to make it work?
And the answer is, well, depends onhow many bad guys there are out there,
how many disinformedinvestors are out there,
because they're the onesyou have to offset.
So you need fewer active investors.
(54:32):
If you, if all the disinformed guysbecome passive investors, one guy,
one belligerent active investor mightbe enough if all the bad ones drop out.
But we'll never know.
>> Jon Hartley (54:48):
Well, Gene, this has been an amazing conversation,
I really wanna thank you for coming on.
It's been a real delight to talkabout your career and ideas and
really just this set of ideas that reallybegan at the University of Chicago,
which you largely led inestablishing modern finance.
Really want to thank you for coming on.
This has been a trulyamazing conversation.
>> Eugene Fama (55:10):
My pleasure.
>> Jon Hartley (55:11):
This is the Capitalism and Freedom in the 21st Century podcast,
an official podcast of the Hoover EconomicPolicy Working Group where we talk
about economics, markets andpolitics policy.
I'm Jon Hartley, your host,thanks so much for joining us.
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