It may or may not have escaped your attention that this year’s Noble Prize in economics was awarded to three American economists; Eugene Fama, Lars Peter Hansen and Robert Shiller. All three have spent their academic lives looking at market pricing concepts in different ways.
Why should that be worthy of this note? Well, Eugene Fama has made a very big impact on how our passive model portfolios are structured.
How you may well ask?
Well, in the 1960s, he developed the Efficient Market Hypothesis which suggests that market prices react quickly to new previously unknown information, implying that any subsequent price movement must essentially be random as the availability of new information is random. If the hypothesis holds true, then trying to beat the return of the market is an exercise in futility. The numerous empirical studies undertaken on active manager performance (those trying to beat the market) bear this out to a compelling degree. A passive approach – capturing market returns – makes very good sense.
In 1992, along with Ken French, Fama also wrote a seminal paper on the incremental returns, relative to the market, that have been delivered by investing in value (less financially healthy companies) and smaller companies. Investors owning market-cap weighted funds tend to own predominantly larger and often growth companies. This paper provided a framework for structuring more diversified portfolios, by making incremental allocations, or ‘tilts’ as they are often known, to value and smaller companies with the expectation of capturing a higher rate of return than the market for the incremental risks taken on.
This work inspired the foundation of Dimensional Fund Advisers, on whose Board he still sits.
His thinking, along with others, has provided us (and many other advisers and institutional investors worldwide) with a sound, risk-based approach to constructing well diversified portfolios implemented using well-managed passive funds.
Sometimes we touch greatness in surprising ways – this is one. We congratulate him on his worthy and long overdue honour.
Click here if you would like to see Eugene Fama talking briefly about the evolution of finance.
Notes and risk warnings
This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily of the Firm and does not represent a recommendation of any particular security, strategy or investment product.
Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
The value of investments and any income taken from them can go down as well as up. Exchange rates may cause the value of underlying investments to fall as well as rise. You may not get back the value of your original investment.
Past performance is not indicative of future results and no representation is made that any stated results will be replicated.
No reader should take any action based on the content of the publication without first obtaining personal advice from Russell Ulyatt Financial Services Ltd. or their own financial advisers.
Errors and omissions excepted.