Eugene Fama and David Booth on the Birth of Modern Finance

Summary

Odd Lots: Eugene Fama and David Booth on the Birth of Modern Finance

Podcast Information:

• Title: Odd Lots
• Host/Author: Bloomberg
• Description: Bloomberg's Joe Weisenthal and Tracy Alloway explore the most interesting topics in finance, markets, and economics. Join the conversation every Monday and Thursday.
• Episode: Eugene Fama and David Booth on the Birth of Modern Finance
• Release Date: March 6, 2025

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Introduction

In this compelling episode of Odd Lots, hosts Tracy Alloway and Joe Weisenthal delve deep into the origins and evolution of modern finance. They are joined by two seminal figures in the field: Eugene Fama, a Nobel laureate often hailed as the "father of modern finance," and David Booth, the founder and chairman of Dimensional Fund Advisors. The discussion is anchored around the newly released documentary, Tune Out the Noise, which chronicles the birth of modern finance and features an array of financial luminaries.

1. The Birth of Modern Finance: Documentary Overview

Timestamp [02:55]

Tracy introduces the documentary, Tune Out the Noise, highlighting its focus on the inception of modern finance and its featuring of prominent figures such as Merton Miller, Myron Scholz, Ken French, and Harry Markowitz. The documentary serves as a backdrop for the conversation with Fama and Booth.

Tracy Alloway: "There's a new documentary out called Tune Out the Noise and it's all about the birth of modern finance and it features an absolutely all-star cast of financial luminaries."

2. Partnership of Eugene Fama and David Booth

Timestamp [05:05]

The discussion shifts to the longstanding partnership between Fama and Booth. Tracy probes into their collaboration and the foundation of Dimensional Fund Advisors.

Joe Weisenthal: "What's the sort of short version of this sort of intellectual partnership and how this firm, Dimensional, came about?"

Eugene Fama: "David was my research assistant 55 years ago... Eventually, he went off on his own, found Dimensional, and came back to me and asked me if I wanted to be somehow involved. We've been going at it ever since."

3. The Role of Data in Modern Finance

Timestamp [06:44]

Booth emphasizes the significance of data in their research and the open-sharing philosophy that Fama advocates.

David Booth: "One of the things I've always admired about Gene is his research, which we use extensively. He's always insisted that his research be in the public domain... So it's so critically important to have an open-air philosophy about sharing research."

Fama reflects on the challenges of data collection in the early days, contrasting it with today's digital advancements.

Eugene Fama: "I worked for a professor at Tufts that had a stock market forecasting service... My job was to come up with new ways to beat the market. It didn't go very well... That was my first lesson on what you can expect by trying to beat the market."

4. Efficient Markets Hypothesis (EMH) and Market Efficiency

Timestamp [12:04]

A core segment of the conversation revolves around the Efficient Markets Hypothesis, with Fama expounding on its nuances.

Eugene Fama: "Efficient markets doesn't say there aren't risk premiums in the market, does not say that at all. It's just a hypothesis. It's not a literal truth. It's just an approximation to the world. But it worked really well for almost everybody."

Tracy raises a pertinent question about EMH's reliance on rational decision-making and its applicability in an era dominated by social media and trend-following behaviors.

Tracy Alloway: "Has your view of the efficient markets hypothesis changed at all over time?"

Fama: "No, it hasn't really changed. It's adaptive in the sense that I never said that the market is efficient for everybody..."

5. Active vs. Passive Investing

Timestamp [16:36]

Joe questions the existence of the financial industry if markets are indeed efficient, pondering why active managers continue to collect significant fees.

Joe Weisenthal: "Why does the financial industry exist if markets are efficient?"

Eugene Fama: "Because there are people who think they can pick the managers that have special information. That's what keeps it going."

Tracy and Joe explore the implications of active versus passive investing, with Booth defending the necessity of diversification.

David Booth: "You ought to have a well-diversified portfolio and in our view ought to include a significant chunk of small cap stocks."

6. Factors and Risk Premia

Timestamp [19:45]

The conversation delves into Fama's work on risk factors and premia, discussing small-cap and value premiums.

Eugene Fama: "So everybody has this confusion. Confusion is mixing together market efficiency and the dimensions of risk in portfolio selection."

Joe probes the sustainability of these premiums, especially in light of prolonged outperformance by sectors like technology.

Joe Weisenthal: "Is there a period at which if growth keeps outperforming value, you say, actually that's not a real sustainable factor?"

Fama: "It's very difficult to unravel the story in the data because there's so much uncertainty associated..."

7. Smart Beta and Modern Investment Strategies

Timestamp [28:00]

The hosts inquire about "smart beta," a popular investment strategy, and its alignment with Fama's research.

Eugene Fama: "Smart beta is a marketing term. Show me a dumb beta."

David Booth: "It's a reflection of the research and the dimensions of returns."

They discuss how systematic approaches can incorporate active decisions, blurring the lines between true passive and active management.

8. The Future of Modern Finance and Data Utilization

Timestamp [36:21]

Booth and Fama contemplate the future trajectory of financial research, especially with the advent of big data and AI.

David Booth: "A lot of these tests of market efficiency... even though with increasing levels of sophistication... it still shows the same outcome that it doesn't look like trying to guess the market is a winning game."

Fama reflects on the exponential growth of financial research and the challenges it presents for new discoveries.

Eugene Fama: "There's been an explosion of research and uses all these new data. And that's been to the plus... Now it's much more difficult. There's much more precedent about what's been done and what hasn't been done."

9. Cryptocurrency and EMH

Timestamp [43:45]

In a thought-provoking segment, Fama addresses the cryptocurrency market through the lens of the Efficient Markets Hypothesis.

Tracy Alloway: "What would be an EMH interpretation of the cryptocurrency market?"

Eugene Fama: "Cryptocurrency gives me all kinds of problems because, like, bitcoin is the only one I'm roughly familiar with... So, what I was saying was, it's not scalable... It's something people are struggling with."

Fama expresses skepticism about cryptocurrencies' longevity, aligning it with traditional monetary theory.

10. Conclusion and Final Thoughts

Timestamp [47:25]

As the episode draws to a close, Tracy and Joe reflect on the insights shared by Fama and Booth, contemplating the practical implications of EMH for average investors.

Joe Weisenthal: "If you try, you will probably end up making mistakes... It's something that I think most people should heed."

Tracy Alloway: "I am not sure I am in the EMH fundamentalist camp just yet, but maybe you can convince me."

The hosts underscore the enduring relevance of EMH while acknowledging the ongoing debates surrounding its application in today's dynamic financial landscape.

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Notable Quotes

1. Tracy Alloway [02:55]: "There's a new documentary out called Tune Out the Noise and it's all about the birth of modern finance and it features an absolutely all-star cast of financial luminaries."

2. Eugene Fama [12:04]: "Efficient markets doesn't say there aren't risk premiums in the market, does not say that at all. It's just a hypothesis. It's not a literal truth."

3. Joe Weisenthal [16:36]: "Why does the financial industry exist if markets are efficient?"

4. David Booth [19:45]: "You ought to have a well-diversified portfolio and in our view ought to include a significant chunk of small cap stocks."

5. Eugene Fama [28:08]: "Smart beta is a marketing term. Show me a dumb beta."

6. Joe Weisenthal [43:21]: "What's the next big research wrinkle that we can do to extend that extends the world a little bit."

7. Eugene Fama [44:01]: "Cryptocurrency gives me all kinds of problems because, like, bitcoin is the only one I'm roughly familiar with."

Key Insights and Conclusions

• Market Efficiency: Eugene Fama reaffirms his staunch belief in the Efficient Markets Hypothesis, emphasizing that while not all information is instantly reflected in stock prices, the overall market tends to price assets efficiently.

• Active vs. Passive Investing: The discussion elucidates the rationale behind active management despite EMH, attributing it to the belief among some investors in their ability to outperform the market through specialized knowledge or strategies.

• Role of Data: Both Fama and Booth highlight the transformative role of data in modern finance, from early manual data collection to today's big data and AI-driven analytics.

• Risk Premia and Factors: The conversation delves into the complexities of risk premia, such as small-cap and value premiums, and their sustainability amid evolving market dynamics and investor behaviors.

• Smart Beta: The term is critiqued as primarily a marketing construct, though it is acknowledged as an extension of research into multiple dimensions of returns.

• Cryptocurrency Skepticism: Fama expresses skepticism about the long-term viability of cryptocurrencies, aligning it with traditional monetary theories and questioning their scalability and practical utility.

• Future of Financial Research: The episode underscores the challenges posed by the exponential growth of financial research, making groundbreaking discoveries increasingly arduous.

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This episode of Odd Lots offers a profound exploration of the foundations of modern finance, anchored by the expertise of Eugene Fama and David Booth. It provides listeners with a nuanced understanding of market efficiency, the enduring debate between active and passive investing, and the evolving role of data in shaping financial theories and practices.

Transcript

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[Bloomberg]

Bloomberg Audio Studios Podcasts Radio News.

[Tracy Alloway]

Hello and welcome to another episode of the All Thoughts podcast. I'm Tracy Alloway.

[Joe Weisenthal]

And I'm Joe Weisenthal.

[Tracy Alloway]

Joe, what's your favorite financial movie? I don't think I've ever asked you that question.

[Joe Weisenthal]

Really? I mean Trading Places.

[Tracy Alloway]

Oh, that's funny. That's mine too. Yeah, and not only cause it's funny, but because it led to a real life development which I don't think a lot of people know, but the CFTC set up something called the Eddie Murphy Rule. I didn't know that because of Trading Places.

[Joe Weisenthal]

I have no idea where you're going.

[Tracy Alloway]

With and I think there has been an enforcement action. Well, what I was gonna say is I think there is actually a lack of really good for financial movies.

[Joe Weisenthal]

Ah, okay. Here you go.

[Tracy Alloway]

Trading Places aside, yes, I would agree with this. Yeah, I know we have the big shore and Margin Call was a very realistic description of what it's like to work at a bank. But I think we need more in our lives and I think we also need financial movies that sort of delve into some of the theories of financial markets. And I get why we don't. Those are really difficult to illustrate in a visual way, but I still want them.

[Joe Weisenthal]

Me too. All right, keep going, Tracy.

[Tracy Alloway]

Okay, well, the good news is I just watched one that fits into that category. So there's a new documentary out called Tune out the Noise and it's all about the birth of modern finance and it features an absolutely all star cast of financial luminaries. So, you know, there are people like Merton Miller, Myron Scholz, Ken French, Markowitz. Like, the list goes on and on and on. And we're going to talk to two of them today.

[Joe Weisenthal]

I'm really excited because I'm finally going to have a chance to ask, is it all priced in? Because this is my core belief about markets that it's like, nope, it's all priced in. And yet there appears to be a financial industry that must on some level be premised on the idea that it's not priced in. But I always assume that it's all priced in. And so maybe we'll finally get an answer to this question.

[Tracy Alloway]

I suspect the way you feel about the term premium is the way I feel about the efficient markets hypothesis. But let's get into speaking with David Booth, the founder and chairman of Dimensional Fund Advisors and Professor Eugene Fama, who is of course a Nobel laureate. He is also a director at Dimensional, has had a long running intellectual partnership with the firm. He's also sometimes called the father of modern finance. I could keep going on with the honorifics here, but you get the idea. I think so. David and Gene, welcome to the show.

[Eugene Fama]

Thank you.

[David Booth]

Well, thanks for having us and looking forward to it.

[Tracy Alloway]

I guess I'll start with the obvious question, but why a documentary movie about modern finance? It is, as I mentioned earlier, not exactly an easy story to tell visually.

[David Booth]

Well, it didn't start out to be a documentary. What happened was we started working with Errol Morris. You know, he won the Academy Award for his film Fog of War and well known documentarian. And we're talking to him about how we could use some of his expertise for our firm. And he got really into it. He had not much background in finance and just got so fired up he wanted to make it his film rather than our film, which I found to be very exciting.

[Joe Weisenthal]

That's cool. We've done an episode with Dimensional's co CEO Gerard O'Reilly. Why don't you Talk to us a little bit about the partnership of the two of you for people who are not familiar, for people who are gonna be watching the film for the first two of you have been working together for literally decades and really two of the biggest names truly in the history of finance. What is the sort of short version of this sort of intellectual partnership and how this firm, dimensional came about?

[Eugene Fama]

Well, David was my research assistant 55 years ago. David, anyway, for several years at the University of Chicago. And finally he came to me, he said, I see what you do and I don't want to do it. So he said he wanted to go off and work in the financial industries. So I called Mac McQuown and got David a job that way with Wells Fargo, I guess it was at the time. David.

[David Booth]

Right, right, in 1971.

[Eugene Fama]

Then eventually he went off on his own, found it Dimensional, and came back to me and asked me if I wanted to be somehow involved. We've been going at it ever since.

[Tracy Alloway]

Oh yeah, this was in the movie. So I think Wells Fargo basically just decided to share some of its data and analysis with Vanguard, like at the very beginning of Jack Bogle's career. And everyone was sort of scratching their heads about why that happened. But do we have any sense of why that happened? Was there just a spirit of research or academic camaraderie that made private organizations share things with each other?

[David Booth]

Well, one of the things I've always admired about Gene is his research, which we use extensively. He's always insisted that his research be in the public domain. We're not in the business of creating black box that nobody understands. So it's so critically important to have an open air philosophy about sharing research. And so Wells got off to a slow start and in some ways, but there was a fundamental question, can you even track the performance of an index? And so Wells had done a lot of simulations and stuff, and when the group I was working on, Wells got shut down, Mac just volunteered to Bogle to share all of his data with him.

[Joe Weisenthal]

Gene, I'm curious, from your perspective, how did this interest you as a intellectual field of study? And we'll get into some of the specific sort of groundbreaking contributions to what many people now consider absolute truths to how the market worked. But some of your ideas, like what attracted you to the study of markets and some of your early research?

[Eugene Fama]

Well, I started on it in college, actually. I worked for a professor at Tufts that had a stock market forecasting service. And my job was to come up with new ways to beat the market.

[Joe Weisenthal]

How'd that go.

[Eugene Fama]

It didn't go very well in the following sense. He was very good statistician, so he always kept a holdout sample. And my ideas always worked in sample, but they never worked out of sample. So that was my first lesson on what you can expect by trying to beat the market. And after that I went off to Chicago, took my day of with me from Tufts and eventually wrote my thesis using that data, which was kind of the first or maybe one of the bigger trumpeting of fish and markets. The term which wasn't even called that at the time. But eventually that term came around as well.

[David Booth]

One of the things that's interesting about that observe he did a study based on data collected by hand. And that was kind of the state of the world. When I went to Chicago to do a research project, frequently he had to hand collect the data. You know, these new kids today wouldn't be aghast if they knew how we did things in the old days.

[Tracy Alloway]

Well, I remember in the old days of Bloomberg we often inputted a lot of financial. If you're working in the global data department, you certainly inputted a lot of things by hand as well. This leads to a question I wanted to ask you. So a big chunk of the documentary is about all these different people who spent time at the University of Chicago. What was in the water at the university that it attracted all these names that went on to do big things in finance?

[Eugene Fama]

Well, Merton Miller was an important person. He was deeply interested in this stuff. And Harry Roberts was another important person who had written on something resembling what would be now called the fishing markets way back in the 50s. So he was very much interested in it. And they were kind of the two shining lights in this area. And plus then there were a lot of PhD students, including me, who needed thesis topics. So having faculty interested in a topic was a good way of having research done by students in that topic because that was the way to graduate. At the time I had two kids with another one on the way. So I was very, very keen on getting out quickly.

[David Booth]

Well, I would also add Jim Laurie, I mean Jim and Larry Fisher. They persuaded Merrill lynch to fund a study to collect a survivorship bias free database which enabled all these new young hotshots to do their research. Until that point, the data had never been collected correctly. And so you couldn't really do the research.

[Eugene Fama]

So when Larry started out to. Larry Fisher started out to collect that data and put it together, a computer didn't exist that could handle it. But he said, well, it's going to come along. By the time we finish this, there'll be a computer. And he turned out to be right.

[Joe Weisenthal]

Well, actually, this is exactly what I wanted to ask, and I think it sort of speaks to like a big theoretical question. Let's say part of good investing is having good data. Like if you have to collect the data by hand, you're already going to probably knock out 99.9% of the people who have interest because I wouldn't do it because my wrists get really tired really fast and my handwriting is garbage. So I wouldn't even be able to read what I had written in the graph paper, et cetera. A lot of things that we take for granted about investing today, including measuring the performance of an index, are things that literally take a few keystrokes or less on a Bloomberg terminal today. And I'm curious, when you think about generating superior returns over time, how much of an edge was that to just be willing to do the hard work of collecting data?

[David Booth]

Look, all these tests of market efficiency, which started in the 60s and keep showing the same result ever since, even though with increasing levels of sophistication of researchers and people having access to more and more more data, better data, faster data, all of that still shows the same outcome of it doesn't look like trying to guess the market is a winning game.

[Tracy Alloway]

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

[Eugene Fama]

No, it hasn't really changed. It's adaptive in the sense that I never said that the macro is efficient for everybody. There are, for example, there's lots of evidence, for example, that company insiders have information that isn't already in prices. So as far as they're concerned, the stock of their company is not priced efficiently. That's one instance of it. But as far as professional managers are concerned, there is evidence that if you give them back all their fees and expenses, there are some who do have enough information to beat the market. But if you don't take out the fees and expenses, then they the active managers look terrible relative to the passive managers. So that's the kind of data in results that makes market efficiency look pretty good. But it's not. It's just a hypothesis. It's not a literal truth. It's just an approximation to the world. But it worked really well for almost everybody.

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[Joe Weisenthal]

Gets to a question that I've asked before, and I now Thrilled to ask it to you, which is, why does the financial industry exist if markets are efficient? Because there are a lot of people that collect very big paychecks from some notion that they can deliver better returns than someone else to their clients. If markets are efficient, at least to most people in the industry, why do we have this industry?

[Eugene Fama]

Because there are people who think they can pick the managers that have special information. That's what keeps it going. That's what keeps the active managers going. It's individuals who don't think that passive investing is for them, and they go with the active people. So that markets are always about competition among different kinds of players, and then we see who comes out on top.

[Tracy Alloway]

Gene, how serious are you when you say stuff like there's no such thing as a bubble or that bubbles are only identifiable after they burst, so it's pointless to talk about them serious? Very serious. Explain it more, because Joe and I have lots of episodes where we talk about either past bubbles or overvaluations.

[Eugene Fama]

Yeah. So with 2020 hindsight, it's always, you know, it's explain why prices went up and why. Why they. Why they went down. But in my view, what a bubble means is price has gone up and you can predict when it's going to go down, when that. That whole phenomenon is going to. The whole price movement is going to go away. And. And that's what's proven them really difficult to do. So lots of people use the word bubble very loosely. I cancel my subscription to the Economist because.

[Joe Weisenthal]

Us journalists are terrible about overusing bubble. I will cop to that on behalf of the entire profession.

[Eugene Fama]

Right. So I need to know what the definition is before I can respond to it. And in that case, that's much more difficult. Most people aren't willing to do that. There are economists that are willing to do it, and they can deal with that. There has to be some predictability about when it's going to end. And that's what's proven really difficult to establish.

[Joe Weisenthal]

Right. It seems fairly clear that you could sort of sense like we're in some sort of mania and even knowing that fact and everyone agreeing on that fact. In fact, to try to establish that fact is often a good recipe for losing all your money if you're shorted or losing all your clients if you're avoiding it. So I certainly take that point. Let me press further, though. So a lot of your research and this idea of market efficiency, but you've also worked on factors that seem over time, historically to outperform. And so the Idea of small companies outperforming big companies or value companies outperforming over time dimensional has funds that aren't just the pure market portfolio. Reconcile the existence of that with the idea of efficient market.

[Eugene Fama]

Okay, that's a good question. So everybody has this confusion. Confusion is mixing together market efficiency and the dimensions of risk in portfolio selection. So going back all the way to Markowitz, we've long known for example that people don't like variance, they don't like uncertainty about future returns and they're willing to pay something to avoid it. So that gave rise to the Shapletner so called capital asset pricing model in which sensitivity to the market was the measure of risk. So basically it's a confusion of prices being reflecting value and the story about what are the dimensions of risk in the market. So that's a confusion that almost everybody seems to have. So efficient markets doesn't say there aren't risk premiums in the market, does not say that at all.

[David Booth]

One way to think about it is define the market to be all the stocks and bonds that are out there. Most of us believe stocks over the long haul will have a higher return than bonds. But few people invest all their money in stocks. It doesn't mean stocks are inefficient, sufficiently priced and just those are the market prices. And you look at different combinations of the two and they provide different distributions of outcomes and just find that distribution that works best for you.

[Tracy Alloway]

So a big chunk of the documentary is about the birth of passive investing and its connection with the efficient markets hypothesis. What's been the impact of the growth of passive investing on the market? Because we often hear that, you know, markets are reflexive moves can end up impacting the market itself. And David, I think you yourself have argued that one of passive investing's biggest flaws is still very much alive, the index effect, where stock prices go up a lot when a company is added to an index. Even though everyone in theory should know that this is going to happen and so it should already be priced in. How has passive actually changed the market?

[David Booth]

Well, that's an interesting question. First off, kind of the impact of an index adding a new name causing temporary prices to go up. That's a temporary effect. It doesn't really impact the long term investor very much. One question that comes up a lot is if everybody indexed then there would be no price discovery and wouldn't markets become inefficient? That's kind of. And my answer to that is, well, let's take a look at the behavior of the market over the last 20 years. There's been an incredible movement to indexing over that time period. And yet there's been an incredible increase in trading volume. I don't think of price discovery as being related to trading volume. So just because there's a big movement to indexing doesn't mean trading volume will decline. What's happened, unfortunately, is it turns out, like a lot of things that can be used for good, they can also be used for bad. And index funds are the ideal market timing vehicle. I'll buy this healthcare index fund and sell my technology fund or whatever it is. And I think that's really kind of what happened in the marketplace is it's kind of turn individual instead of individual stock selection. It's kind of like a big gambling casino where you have a lot of different ways you can make your bets. So it doesn't look like, in terms of the basic notion of market efficiency, it doesn't appear to have had much impact on that.

[Eugene Fama]

Let me take a different direction. People worry that if everybody goes passive, how will prices get formed? And that's a legitimate concern. But then the issue is who drops out, who doesn't go active anymore? If it's bad active managers, people who have no special information, if they drop out, then you need fewer good active people to keep prices in line. So it depends on who drops out as to whether it has any effect at all on market efficiency. Now, we haven't been able to discern anything like that in the behavior of prices, but that is the question since.

[Tracy Alloway]

We'Re on the topic of indexing. You know, the market nowadays, as you mentioned, is basically defined by benchmark indexes, things like the s and P500 or the MSCI World Index. And the benchmark index providers will often say that they're just holding up a mirror to the market as it exists. They're neutral. But it seems kind of obvious to me that their decisions do impact the market. And some of those decisions can be subjective. You know, when it comes to measuring things like liquidity or how developed a particular bond market is or whatever. Are we just outsourcing investment decisions to index providers?

[Eugene Fama]

You have to choose the one you want. So my own takes run in the direction of a total market index being a good choice for almost, almost everybody. So I don't, I don't go for the subset things like 30, but I have 30. Dow Jones, that was always kind of dumb, but. Or even the s and P500, that's only 500. There's a lot more stocks out there than that.

[David Booth]

Let me just recoil against the term passive. You know, in my view, there's no such thing as passive management. And you're getting, you're touching on something right there. You know, the different index providers and how they do it, and they all do it differently and so forth. And, you know, Standard and Poor's, when it wants to add stock to its s and P500, the investment committee sits around and talks about, what do you like? The s and P 500 is 500 of the largest companies, but it's not the 500 largest companies. And there's quite a bit of subjective judgment goes into deciding what stock goes into the index, which, if you're going to an index fund because you don't like stock selection, that's not the kind of activity you want to see.

[Joe Weisenthal]

I want to go back to this idea of even if markets are efficient, there still are risk premia and certain asset classes are expected to go up more than others due to people wanting to avoid drawdowns, et cetera. You know, like, I don't make many active decisions. I'm like a good, Like, I follow what I read in the news and I, like, have some stocks and, you know, probably have some Treasuries and some fund or something like that, and I don't pay attention to it much. Looking back, though, at historical trends in portfolio construction, I sometimes wonder, why should anyone own bonds? Because you say hardly anyone just owns stocks, and that seems to be objectively true. But I wonder if, like, is there reason to question some of this dogma of like, why, like, if I'm not going to retire in 30 years, do I care about, you know, I'm already diversifying over time because I make an allocation to my retirement funds with every paycheck, so I'm already getting time diversification. Are there fundamental questions in portfolio construction that you think need to be rethought if over the next 30 years before I can retire? 25 years maybe. If almost everyone thinks it's certain that stocks will outperform bonds, why am I holding bonds?

[Eugene Fama]

That's almost. But he thinks that's true, but it's not true. Stocks don't get less risky in the long term, risk accumulates.

[Joe Weisenthal]

So I don't understand that. I don't, I don't understand how in.

[Eugene Fama]

This case, when you retire. When you retire. Yeah, period. When stocks have done particularly poorly and you, you will get hurt. That's always a possibility. It doesn't go away with time. So the presumption is is what's incorrect. The risk is always there. You don't get rid of it.

[Tracy Alloway]

What do you think about the term smart beta and is dimensional doing smart beta?

[Eugene Fama]

Yeah. Smart beta is a marketing term. Show me a dumb beta.

[Tracy Alloway]

I'm sure I could find some examples, but they certainly wouldn't have set out to create dumb beta.

[Eugene Fama]

There's a lot of marketing, remember, there's a lot of marketing in the financial business. That's one of them. That's one of the big ones.

[Joe Weisenthal]

What does it mean to you? So, like, when you hear that term, like, what is the person trying to sell to me?

[Eugene Fama]

Well, you have to give me an example because I don't take it seriously. Obviously you can tell by me chuckling here.

[David Booth]

Well, I think it's Gene's research that he did with Ken French, his landmark 92 paper called Cross Section of Expected Returns. Anyway, that kind of gave empirical support to the idea that there can be many dimensions of returns. So if you focus on a certain dimension. Some people came up with the term smart beta. It's not smart. I mean, just. It's just, you know, a reflection of the research and the dimensions of returns. You know.

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[Joe Weisenthal]

Something that I'm really interested in when it comes to markets, particularly I would say over the last 15 years since the great financial crisis, small caps have certainly not provided any sort of superior risk adjusted returns to large caps. And you can see that on basically any chart. And growth companies year after year by the traditional metrics of what we call growth and value. And I know people sometimes try to redefine these to allow them to put Nvidia in their value fund. Clearly, growth has been outperforming for a long time. And part of the reason it seems very obvious to me that these big tech stocks have done so well is because the companies have all done extraordinarily well in beating earnings expectations year after year after year. Does this pose a problem for a sort of factor oriented investor when the fundamentals of one sector, the real fundamentals, not the stock performance, produce these abnormal periods of profitability growth?

[Eugene Fama]

Well, I don't know how abnormal they are. So the essence of all these dimensions of returns is that they're risky. The results are highly uncertain over any finite period, over any period of time. So they can do poorly for long periods of time. They can also go away. If too many people jump on things, it can cause them to go away. So it's possible, for example, that interest in small stocks and interest in value stocks kill the size and the value premiums that existed in the historical data. That's quite possible. Pricing of securities is no more than supply and demand. So if the demand goes up and the price goes up with it, then you can see these premiums disappear. It's very difficult to unravel the story in the data because there's so much uncertainty associated, so much volatility associated with prices and returns. But these are always possibilities that these dimensions of risk are no longer compensated because people don't fear them anymore. They jump into them if they Think the returns are better? That's always been a possibility. Ken French and I pointed that out in the initial papers we wrote on the dimensions of risk.

[Joe Weisenthal]

So just to press on this point further, small companies are always going to have certain types of risks. Low liquidity stocks are always going to have certain types of risks that don't exist in high liquidity stocks. But when you think about these factors, these do not strike you as iron laws of how markets work, that you will at some point get compensated for taking on these risks into your portfolio.

[Eugene Fama]

Well, you're mixing in trading costs there. So there are differential trading costs and different kinds of assets, differential transactions costs. Those are part of what you pay in order to play the game. And in principle they detract from the prices of the stocks. But I'm not sure about what your question was actually.

[Joe Weisenthal]

Basically the idea that at any given point you will be compensated for the risks of smaller, less liquid stocks. That's not necessarily a permanent characteristic of the market.

[Eugene Fama]

Well, that was always a dimension of risk, which means there's volatility associated with it. So historically, during the periods when over the long term small stocks did very well, there were always periods when they didn't within those periods, within their periods of good return. So that's always true. So there have always been periods when stocks did worse than bills, with a long period of that in the 30s, 40s, all the way up to the 50s. So these are just dimensions of risk and return, basically. And risk means you can lose.

[David Booth]

Well, may also point out kind of the direction you're headed is what we believe is, at the end of the day, you need to come up with sensible portfolios and well diversified, low cost and so forth. And when we started the firm, we built it on the idea that you ought to have large and small cap stocks in your portfolio. Not just large cap. Our first clients were large institutional clients and they were only holding stocks of bigger companies because they were trying to. They hired managers to outguess the market. And you can't build a business, much of a business, trying to pick the winners of the small caps because you can't buy enough of them to create a profitable business, or it's hard to anyway. So the thrust wasn't so much that we guarantee you higher returns. The thrust is you ought to have a well diversified portfolio and in our view ought to include a significant chunk of small cap.

[Tracy Alloway]

David, you highlighted earlier the importance of data in modern finance, and that definitely comes through in the documentary. The idea that a lot of these studies and theories went hand in hand with the development of, to Gene's point, you know, computers and the ability to actually track more information and crunch it more efficiently. Nowadays it kind of feels like we're drowning in data. Almost everything is tracked. There's artificial intelligence, generative AI, all this stuff we could use. Do you see any new interesting ways of using that data or any interesting ways that data is being translated into either new financial theories or investment strategies?

[David Booth]

Well, you know, kind of Gene's view is the market reflects all available information. That's kind of the implication of efficient markets. And with these AI programs and so forth, I mean, they have vast amounts of data, but no AI algorithm can reflect all available information. So even though they have lots of information, there's still lots that get reflected seemingly in stock and bond prices.

[Eugene Fama]

Looking at it from the academic side, what's happened with the coming of so many big databases, let people do lots of research, is that research and finance has expanded. There used to be just a few of us still doing it in the 60s and 70s. Now we have big finance departments in almost every school, all with people who want to do work. Most of it work on.

[David Booth]

On.

[Eugene Fama]

Lots of it work on. On market. So where there was basically one journal in this in the 60s, it was it all open to this kind of stuff. Now you have four or five of them that are all pretty good now coming up with new stuff, publishing three or four times a year. So there's been an explosion of research and uses all these new data. And that's been to the plus, I think when I talk to my young people, I say, boy, in the old days it was easy. When I was coming up, it was like shooting fish in a barrel. Nobody was doing anything. So everything he did was new. Now it's much more difficult. There's much more precedent about what's been done and what hasn't been done.

[Joe Weisenthal]

You started this conversation by talking about your initial problems, which is that when you're identifying historical patterns, it's easy to find something that works in sample and then it doesn't work out of sample. So I could probably come up with some story that tickers that start with the letter P tend to outperform on Tuesdays. And I could find some chart that shows that absolutely for years and years and years this the case. And then of course, you know, that's totally made up. And so then it doesn't work. And we've seen this explosion of other factors. You have your three factors, but people are coming up with all kinds of factors and you've added factors, et cetera. When do you say like a factor loses legitimacy? It's like, you know what? This was p hacked. This turned out to be. It turned out that actually it doesn't really work out of sample after a long enough time. And in my mind I am going back to say value versus growth or small versus big here. Is there a period at which if growth keeps outperforming value? You say, actually that's not a real sustainable factor. It's not mean reverting. And this was a. The appearance of these excess returns was a function of limited sample size.

[Eugene Fama]

Okay. So Ken French and I have always been very sensitive to exactly this problem. So every time we did a paper that seemed to have a new result discovered in it, we would consciously extend the data backward in time and see if the same pattern were observed. And then we'd go international and see if the same pattern was observed in another market. So we were very sensitive to precisely the issue you're raising. And it's a very important issue. Not many people do that. They don't look at out of sample data to see if it worked there. Now, we only went forward when we found things that seemed to work. Looking backward in time, which is one way of going how to sample and looking across markets, which is another way of going out of sample. But still, it's possible that the discovery of the effect causes people to move to it, to do stuff that basically makes it go away. And it takes a long time before you can tell that that's true. Because of the basic nature of the uncertainty of the whole process, the amount of uncertainty there is about the evolution of prices. There's really no way to get around that. So we won't know how. Life in my life, my lifetime anyway, but I'm 86 years old. We won't know in my lifetime whether the value premium or the size premium have actually gone away because you still don't have enough data to come to that conclusion.

[David Booth]

Well, also let me add one additional thing to when Gene and Ken did all this great research, they have the data there that jumps out at you. Then one of the questions was always, why would it be there? And you can go through the algebra, why low price stocks have higher average returns than high priced stocks. It seems sensible that there would be that low priced stocks might have higher expected returns because it may be because they're riskier.

[Tracy Alloway]

Gene, towards the end of the documentary, just on the notion of going forward, you kind of talk about what's next in modern finance. And you make the point that we are not making these sort of quantum academic jumps as we did in the 1970s, and that someone needs to come up with a new innovation, a new burst forward, but you don't really know who that might be. Do you have any sense of where people should be looking for the next big thing in modern finance or modern financial theory?

[Eugene Fama]

That's, again, an excellent question, but I think the answer is all that stuff is basically unpredictable. You don't know where the new direction is until somebody discovers it. And where people think it might be almost always turns out to be the wrong place. Not that you shouldn't do it, but simply, it's a very difficult task. So the question is excellent. The answer is unavoidably vague.

[Tracy Alloway]

Fair enough.

[Joe Weisenthal]

There's nothing. If a young student came to you and said, hey, I'm looking at 86, you might not want to dive into something new. But there's nothing. He's like, oh, yeah, I'm sort of curious about that. You should try to pursue a. Write a paper. There's nothing that comes to mind that sort of. You would suggest a young researcher make a stab at.

[Eugene Fama]

Well, the question we started with was, what's the next big.

[Joe Weisenthal]

Yeah, right, right. Okay.

[Eugene Fama]

It changes the world. That's much more difficult. What's the next research wrinkle that we can do to extend. That extends the world a little bit.

[Joe Weisenthal]

Fair enough.

[Eugene Fama]

That's mostly what goes on in research. The small little steps forward and sometimes little steps backwards stuff doesn't work out.

[Tracy Alloway]

Since we have Gene Fama here, I cannot resist asking a sort of thought experiment question. But what would be an EMH interpretation of the cryptocurrency market? Can you look at it through an EMH lens?

[Eugene Fama]

I was wondering when you were come to that. But cryptocurrency gives me all kinds of problems because, like, bitcoin is the only one I'm roughly familiar with. But nobody can explain why it survives, because basically, the old monetary theory says this. Something that has a highly variable real value can't be used as the medium of exchange because people won't want to deal with it. So, for example, a business that doesn't want to do business in terms of bitcoin because the variation in the price of bitcoin itself can knock the company out of business. So then the question becomes, who does want to use bitcoin? Historical monetary theory, as I learned it, it's not capable of answering that question. So it would have predicted, and I'm still predicting that it'll bust.

[Tracy Alloway]

It.

[Eugene Fama]

It'll bust. At some point people will say, no, that's it. And they'll start piling, piling into it. And then the market, debt market will just disappear. But we'll see if it survives. We need a whole theory to explain how and why.

[Tracy Alloway]

That sounds suspiciously like you're saying it's in a bubble.

[Eugene Fama]

Oh, that's. I'm hoping it's in a bubba, is what I'm saying.

[David Booth]

Well, I think it may be that he's also saying that if crypto is going to survive, it'll be because it has some value right now. And it could, maybe someday you can do transactions cheaper than you can with MasterCard or something.

[Eugene Fama]

That's a good point, David, because there's a difference between the medium of exchange and the method of exchange. So the method of exchange is how do you carry out the transactions? The medium of exchange is what do you put into it in order to carry out the transaction? So the question is about the methods. The methods evolve all the time. So we have a central bank method now that we use pretty much for every everything in the US but the blockchain is an alternative kind of mechanism. What you put into it can be anything. It can be. Can be Bitcoin or it can be dollars, because it didn't really matter. So those are two different things. So people worry that a system where a central bank manages the transactions, which is the system we have, is too open to manipulation by the government and that the blockchain avoids that. But then it turns out that the blockchain is not scalable. Its complication goes up basically exponentially as it handles more transactions. So that's not the answer to the method of exchange problem, and that's something people are struggling with.

[Tracy Alloway]

All right, David and Gene, we're going to have to leave it there, but thank you so much for coming on Odd lots. It was, it was a real pleasure to speak with you both and congrats on the movie.

[David Booth]

Okay, great, thanks. It was really a lot of fun.

[Tracy Alloway]

Joe. That was really fun. Fama especially, was someone I always wanted to speak to. I do have to say, you know, I mentioned earlier the way you feel about the term premium is probably the way I feel about the efficient markets hypothesis. And I recognize it's a theory that exists, but I guess I'm not sure how useful it is to basically say that the average investor can match the average return of the market. Does that lead anywhere?

[Joe Weisenthal]

Yeah, yeah, it absolutely leads somewhere. It means that you almost certainly shouldn't try, and that if you try, you will probably end up making mistakes. I mean, I think that's like such.

[Tracy Alloway]

A depressing view of human capability.

[Joe Weisenthal]

I think this is one of the most useful maxims in finance, because even if it's not formally true, right, Even if there are slight variabilities, et cetera, I do think it seems very clear that the vast majority of people, including many professionals, as the statistics have borne out, can't actually generate superior returns. And so if the only thing that we like, if the only use we get out of the efficient markets hypothesis is like, do something else with your life than trying to beat the market. That sounds like wonderful advice that I think most people should heed.

[Tracy Alloway]

Should you say that on the All Thoughts podcast?

[Joe Weisenthal]

Well, that's the funny thing. It's like, why are we all here? I mean, this is like the existential question of everything. Because, like, my interpretation of Gene's answers is basically a recurring series of yes, it's priced in, yes, it's priced in. Yes, it's priced in, yes, it's priced in. And so I do have this existential question about we support this news organization that supports an industry and I talk about this stuff all the time. And then it's like, why?

[Tracy Alloway]

I think I'm closer to David's position on this where, you know, true passive doesn't necessarily exist. There's sort of a middle ground where you can have systematic approaches, but you're still making active decisions in the way you either execute trades or, you know, in the cost of your investment and things like that. I think that's a reasonable middle ground. I am not sure I am in EMH fundamentalist camp just yet, but maybe you can convince me.

[Joe Weisenthal]

Yeah, you know, here's what, here's my. This is not the weak form. There's a definition of the weak form. Efficient market hypothesis. What I would say is this, and I've actually given this advice to other journalists, and I think this is something that I could try to convince people of, which is that if you look at the market and you think that you identify some security or anything that seems to you obviously mispriced, you should start with the presumption you're missing something. It's very unlikely that you've just seen something in the market that obviously you can profit from, it occasionally happens and people have a thesis and something looks clear and they make a lot of money. But I think most of the time, if you see a line, you're like, it shouldn't be there. You should start with the assumption that the billions of dollars flowing through the market didn't all miss something that you see as obvious.

[Tracy Alloway]

Yeah, but there are people who outperform the market. And it's a little bit like, again, tautological, I guess just to hand wave it away and be like, oh, they got lucky.

[Joe Weisenthal]

Yeah, right. But can you identify the people who. Right, this is the problem. Like, right.

[Tracy Alloway]

Yeah, no, this is.

[Joe Weisenthal]

And this is why you. This is why all these things break.

[Tracy Alloway]

Maybe I just break your brain. Maybe I was lucky in choosing the lucky investment manager. How about that?

[Joe Weisenthal]

I mean, that's right. That's like. I mean, that's like, you know, manager selection suffers from the exact same problem as stock selection. The out of sample in sample bias. This is why. But one thing I am curious, like, when we are long dead and maybe the Odd Lots franchise is so valuable that there's like, you know, there's like new hosts of the podcast, right? Because they want to continue it. Maybe they'll be alive long enough to say, like, oh, turns out there's no small cap premium after all. Because Gene opened up the possibility that, yeah, we all of finance and economics suffers from the tragedy of small sample sizes. Like, it's like this known phenomenon, like the world is just getting started. Maybe one day it'll be like, actually turned out that wasn't really a thing. But that'll probably be after all of our lifetimes.

[Tracy Alloway]

In the long run, we're all dead. Since you mentioned in the long run.

[Joe Weisenthal]

All factors are dead. All factors are suffer from sample bias.

[Tracy Alloway]

Since you mentioned the small cap stocks, there was this little visual in the documentary where they showed a headline from, I think it was the early 1990s and the headline was mutual funds offbeat theory by stock in smaller firms. And I thought that was so funny and kind of quaint because they're basically talking about growth stocks. And you know, nowadays growth stocks are sort of an accepted idea, but back then it was offbeat, an offbeat theory. And it kind of shows just how much financial theory is embedded in the market now that we take for granted. But a decade ago or two decades ago or five decades ago, people didn't know it well.

[Joe Weisenthal]

And just on this one point, it is interesting too that now if someone says growth stocks, you think really big companies. And there was a time when if someone said growth stocks, you'd think about really small companies and that big companies were supposed to grow slowly. And so this is kind of what I wonder about. Like, these like, are fundamental realities of business changing and could those fundamental realities of business changing change fundamental aspects of the stock market? Because we now have this era where you have gigantic companies still putting up growth numbers that in any time would be incredible.

[Tracy Alloway]

All right, shall we leave it there?

[Joe Weisenthal]

Let's leave it there.

[Tracy Alloway]

This has been another episode of the All Thoughts podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway.

[Joe Weisenthal]

And I'm Jill Wiesenthal. You can follow me at the Stalwart. Check out the new Errol Morris documentary Tune out the Noise that talks about all of these things and the beginnings of modern finance. Follow our producers Kerman Rodriguez, Ermenarman, Dashiell Bennett at dashbot, and Kell Brooks at Kellbrooks. For more Odd Lots content, go to bloomberg.com oddlots where we have a newsletter, our episodes and a blog and you can chat about all of these topics including endless circular discussions about market efficiency in our Discord, Discord, gg, Oddlauts.

[Tracy Alloway]

And if you enjoy Odd Lots, if you like it when we in fact have an endless discussion about the efficient markets hypothesis, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad free. All you need to do is find the Bloomberg Channel on Apple Podcast and follow the instructions there. Thanks for listening.

[A16Z]

In a world of pocket computers and AI poetry, it can feel impossible to keep up. If that resonates with you, join me over on the A16C podcast as we chat with the innovators shaping our future like Apple co founders Steve Wozniak, A16Z co founders Mark Andreessen and Ben Horowitz, or the very first CTO of the CIA from the science and supply of GLP1s, or even self driving cars and boats. Eavesdrop on the Future with the A16C podcast. I'll see you there.