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

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.

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.

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.