Strategic Fixed Income
Core
Tactical
PERSPECTIVES
NOTES FROM A FIRESIDE CHAT WITH EUGENE FAMA
EFFICIENT MARKETS – VOLATILITY – SECURITY SELECTION & WEIGHT
In September Eugene Fama and I had what was called
a “fireside chat” at the University of Chicago
(although I’d like to point out that there was no
fireplace). It was an honor to be with him - I haven’t
seen him in person since 2005.
Mr. Fama is described as the “father of efficient
market hypothesis”1 and the “father of modern
finance”2. According to the University of Chicago,
“Through his research he has brought an empirical
and scientific rigor to the field of investment
management, transforming the way finance is viewed
and conducted… (he) is among the most cited of
America’s researchers”3.
will mean) that markets are not volatile.
2. “The market” is not the S&P 500, or the Dow
or even US equities. “The market” is
comprised of the universe of all investable,
tradable wealth. This transcends all assets
and asset classes on the planet.
3. Active management has to be a zero sum
game by definition.
4. Negative skill clearly exists.
The portfolio implications are vast and fall into three
categories:
1. Volatility happens.
2. Portfolio weightings should start with an
understanding of “the market”.
His main points were:
1. Efficient markets are volatile markets.
Efficient never, ever, ever meant (and never
3. Security selection: details on the active /
passive debate and portfolio composition.
ABOUT THE MANAGER
Tom Anderson is an Executive Director – Wealth Management, a Senior Portfolio Management
Director, a Family Wealth Director and Financial Advisor with Morgan Stanley. Tom has his MBA
from the University of Chicago and a B.S.B.A. from Washington University in St. Louis. A member
of the Investment Management Consultants Association, Tom passed his Certified Investment
Management Analyst, (CIMA®) examination at Wharton School of Business in 2002. In addition,
Tom has earned the Chartered Retirement Planning Counselor (CRPC®) designation through the
College for Financial Planning. Tom has received multiple national recognitions for his Wealth
Management accomplishments.
Please continue reading for detailed notes on our
conversation and the implications for our portfolios.
Background
Regardless of whether you believe in Professor
Fama’s theories, he is known as one of the most
influential people in the financial industry and his
influence on my approach to portfolio management is
hugely significant. If you are not familiar with him, I
recommend that you Google “Eugene Fama” and / or
read the citations at the end of this commentary.
It is easy to skip over that suggestion so I’ll tell you
again that if you really want to understand a
cornerstone of the foundation that shapes my
perspective, it is important to be familiar with Fama’s
work.
With that background, let’s dive in:
1. Efficient markets are volatile markets
As you can imagine, the conversation went directly to
what everyone is wondering about when they sit down
with the godfather of efficient market theory:
If markets are so efficient then how did 2008
happen?
Professor Fama said that efficient markets are
volatile markets. We talked about the fact that it is a
misconception that an efficient market is not a volatile
market. Efficiency and volatility don't have anything
to do with each other.
Professor Fama said, “Efficient never, ever, ever
meant (and will never mean) that markets are not
volatile.” He said that diversification absolutely
worked in the crisis as residual variance /
idiosyncratic risk (firm specific risk) was eliminated.
For example, multiple firms failed during 2008 but if
you held the entire sector, you survived.
According to Professor Fama, diversification does not
mean that there is a lower bound, nor does it mean
that there is no volatility. He said that now, more than
ever, investors need to familiarize themselves with his
research, and specifically, with portfolio theory. There
is a big difference between losing 50% of your capital
and losing all of your capital.
It is also important to note that there were negatively
correlated assets during the crisis (such as long term
treasuries) that went up in value. This further
illustrated the importance of diversification. Just
because many investors didn’t own the assets that
were rising doesn’t mean markets weren’t efficient - it
in fact proves they are.
For example, a portfolio that was 50% long-term
treasuries and 50% equities did reasonably well on an
absolute basis and incredibly well on a relative basis.
Too often investors think of wealth as an absolute
concept, but of course, in reality it is a relative
concept. Imagine having $1 million in 1913 or having
$1 million today. They are in no way close to being
equal as the $1 million in 1913 would be roughly
equivalent to the purchasing power of $23 million
today4. What matters is the purchasing value of money
at any given point in time.
One could argue that 2008 was the best example ever
of the importance of investing in globally diversified
portfolios across all asset classes, which leads us to
the next topic.
2. “The Market” is not the S&P 500
If you have ever heard Professor Fama talk you know
that he throws around the term “the market” all the
time.
I’ve been waiting for years to ask him a specific
question so, like a kid in a candy store, I asked him
the following, “Professor Fama, you keep referring to
“the market”. Clearly “the market” isn’t the S&P 500
so what is it? How would you define it?”
Answer: “The market is comprised of the universe of
all investable, tradable wealth.”
He went on to observe that this transcends across all
assets (and therefore all asset classes) on the planet.
Note the significance of this statement. The
components are essential as first it implies the
importance of a global, world neutral perspective and
second he limits it to “tradable” wealth.
This distinction (in my mind) implies the importance
of liquidity that is best reflected in global capital
markets. Next time I see him I promise to get more
color on his take of why he so clearly said the words
“investable, tradable” wealth and the implications on
private equity, non-publicly traded real estate,
residential real estate and other asset classes.
This makes intuitive sense: we all know that the
market is not the S&P 500, or the Dow but it leads us
to questions such as:



Why do so many investors want to benchmark
against those indices?
Would you benchmark versus the S&P if you
lived in Europe? What if you lived in Asia? Or
Canada?
Why don’t more investors start their framework
with a world neutral perspective?
Our portfolios are structured for US clients and I
understand the natural reaction of US based investors
to want to overweight our country but what is the
scientific justification for this?
If the issue isn’t clear than I suggest turning the
question around for better perspective. Imagine
traveling to Spain and sitting down with a Spanish
friend. Your friend wants advice on how to invest
money. Knowing that with today’s markets you can
invest money all around the world, what would you
advise? Should they invest 85% of their money in
Spain? Should they invest 85% of their money in the
United States?
Starting a portfolio allocation process with a world
neutral framework is the only logical place to begin. It
can be modified from there, but that is the logical
starting point for the allocation framework.
The tendency to overweight your home country or
region is called “home bias” (Google “home bias in
investing” for over 6 million hits). It is not just a US
phenomenon, it happens throughout the world. As
Investopedia observes, “investors from all over the
world tend to be biased toward investing in domestic
equities. For example, an academic study from the late
1980s showed that although Sweden possessed
a capitalization that only represented about 1% of the
world's market value of equities, Swedish investors
put their money almost exclusively into domestic
investments.”5
3. Active management has to be a zero sum game
by definition.
The market itself can grow and create value as a
whole through earnings growth overtime. However,
since all managers are buying and selling within the
same market, their activities have to be a zero sum
game. There are an offsetting number of “winners”
and “losers”.
Professor Fama says that, obviously, looking
backward, some managers are going to outperform.
You would naturally expect this. In fact, let’s start by
looking at what one may have as a base expectation
for outperformance and compare it to the actual data.
One might start by assuming that the market
represents the “average”. If that is the case, then it
might be fair to assume that perhaps 50% of managers
are above average and 50% are below average,
making selecting a “good” manager a 50 / 50
proposition.
What Professor Fama has found is that from the
whole population of mutual funds, only 3% have
beaten their index after costs. He suggests that for
those who “won” it is 100% attributable to luck.
He went on to point out that the “luck” wasn’t even as
high as you would anticipate: in a perfect distribution,
you'd think that you would have even more than 3%
who would be delivering value - even if it was just
luck.
In looking at the top 3%, the important question for an
investor is whether or not one is able to identify those
same managers (the “winners”) looking forward.
Professor Fama feels that the data clearly shows that
we are not. There is no clear way to identify winning
managers on a forward-looking basis. The statistical
uncertainty is too high and that looking forward there
is a 97% chance the manager you select will not beat
their index on an after fee basis.
His take: why bother? People should be 100%
positioned in a passive allocation framework
(indexing).
Don’t believe it? Test his theory!
Start with the S&P 500 since it is most familiar to US
investors. Can you name (without research) just 5
managers who have beat the S&P 500 on a 1, 3, 5 and
10 year basis?
Now try researching it. Can you name them now?
I think you will find it a difficult exercise.
there are fewer winners than you would perhaps
expect (that the market is above average, not average).
In order to determine the value added by active
management in a portfolio, an investor needs to
subtract the aggregate losses of those who
underperformed from the value added of those who
out performed to determine the aggregate value added
or destroyed by utilizing active strategies.
Even if you identify a winner in one category, the
odds are too high that you will have a loser in another
category who will take away your winners’ gains.
Portfolio Implications
The portfolio implications are vast. It starts with an
acceptance of his research and the facts around it.
Many people would perhaps “like” or “want” his
statistics to not be true. After all, a world where we
could easily identify “winners” would be so much
easier and convenient for all.
The background section is important because you
either need to take a leap of faith and trust me on the
data I have shared, or if you disagree, I suggest that
you need to familiarize yourself with his research and
then offer up alternate empirical research that proves a
different view.
Once we accept the premise, then the implications fall
into three categories:
1. Volatility happens
If you can please send the names to [email protected]
4. Negative skill clearly exists
He also talked about the fact that a lot of managers
have negative skill. He said it's not a comfortable
concept to talk about, but what it means that some
people are clearly out there destroying value. He
talked about the surprising fact that many people are
doing it on a consistent basis.
Looking at the data cited above, he would observe that
2. Portfolio weights should
understanding of “the market”
start
with
an
3. Security selection: details on the active / passive
debate and portfolio composition
Volatility Happens
Efficient markets are volatile markets. Investors can
not anticipate volatility but instead need to proactively
position for it by diversifying and comprising
portfolios with allocations to multiple asset classes
that have negative correlation. You need to have some
yin and yang in your portfolio.
Portfolio weightings should
understanding of “the market”
start
with
an
I absolutely 100% agree with his definition of the
market. The market is comprised of “the universe of
all investable, tradable wealth”. This transcends all
asset classes and all geographies. We need to hold this
perspective in mind and start with a world neutral
framework for asset allocation within each of our
models.
Security selection: details on the active / passive
debate and portfolio composition
Portfolio management starts with security selection. A
portfolio manager (or an investor on their own) can
choose to do one of the following:

Select individual securities (and, in effect, act
as the active manager)

Hire an active manager

Use passive management (Indexing)
Most people know where we stand in the active versus
passive debate: Index! We are familiar with Fama’s
research, the data is compelling and we believe that
passive is the way to go.
I joke that at The University of Chicago they used
long sticks with barbs on them to beat this belief into
us.
The problem with individual securities is that 1.) It
can expose the investor to “firm specific” risk
(idiosyncratic risk or the risk that any single company
can go bankrupt) and 2.) It is a form of active
management which, according to Fama’s research,
doesn’t add value 97% of the time.
This leads us to indexing. The only way to get
exposure to the index is to own the index. In the case
of the Russell 3000 this means that an individual
would need to own 3000 securities in an account to
represent the index. Since this changes often (weights
and positions), it is practically impossible for an
individual to replicate the index in a cost effective
way. Therefore, investors turn to exchange traded
funds (“ETF’s”).
The problem is that there are over 1,400 ETF’s, 6
tracking hundreds of indices. In fact, you may Click
here for an article on the problems with ETF’s or here
for Bloomberg’s “12 things you should know about
ETF’s”.
The biggest problem however comes in when we start
to look at some other asset classes: areas such as
commodities, foreign bonds, global real estate and
certain areas of US fixed income. These asset classes
have indices but the ETF’s that track them often have
very high expenses and very high tracking errors.
Implementation is complicated. With our open
architecture platform there are areas where I can own
active managers at a cost equal to or less than many
ETF’s.
I also believe firmly that if one chooses to use active
management, they would have to subtract the value
destroyed by the “losers” from the value created by
the “winners” to get a true determination of value
added through active management.
We start with a preference for indexing but are very
receptive to active management in certain asset classes.
We look at it on a case-by-case basis and think that a
properly positioned, globally diversified portfolio
(across all asset classes), should be comprised of both
active and passive managers.
Where the discussion gets interesting is when it gets
down to implementation.
We overlay the security selection process with our
risk dashboard and forward looking risk, return and
correlation assumptions to determine the weighting
for each position.
As Charlie Munger said in a conversation with
Howard Marks, “It’s not supposed to be easy. Anyone
who finds it easy is stupid.”
As the market technology moves forward, I fully
expect there to be higher weighting each year toward
passive management. Until then, I remain grateful for
two things:
1.) The flexibility in our open architecture platform to
make the best decision on an asset class by asset
class basis for our clients
2.) Professor Fama’s important research, perspective,
and influence on our portfolios and the time he
has spent with me.
For more information please contact:
Thomas J. Anderson
Executive Director - Wealth Management
Senior Portfolio Management Director
Financial Advisor
[email protected]
70 WEST MADISON SUITE 5450
CHICAGO, IL 60602 312-443-6013
4015 GLASS ROAD
CEDAR RAPIDS, IA 52403 319-743-6074
International investing may not be suitable for every investor and is subject to additional risks, including currency fluctuations, political factors, withholding, lack
of liquidity, the absence of adequate financial information, and exchange control restrictions impacting foreign issuers. These risks may be magnified in emerging
markets.
This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives
of persons who receive it. The strategies and/or investments discussed in this material may not be suitable for all investors. Morgan Stanley Smith Barney LLC
recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a Financial Advisor. The
appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.
Please contact your Financial Advisor for a complete listing of all transactions that occurred during the last twelve months.
The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley or its affiliates. All opinions are subject to change
without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is
no guarantee of future results.
Portfolio Management is an advisory program in which the client’s Financial Advisor invests the client’s assets on a discretionary basis in a wide range of securities.
This material is intended for use only in Morgan Stanley’s Advisory Program.
The performance, holdings, sector weightings, portfolio traits and other data for an actual account may differ from that in this material due to various factors
including the size of an account, cash flows within an account, and restrictions on an account.
S&P 500 Index is an unmanaged, market value-weighted index of 500 Stocks generally representative of the broad stock market. An investment
cannot be made directly in a market index
Please be advised by clicking on a third party URL or hyperlink, you will leave morganstanley.com. Morgan Stanley Smith Barney LLC is not implying an
affiliation, sponsorship, endorsement with/of the third party or that any monitoring is being done by Morgan Stanley of any information contained within the web
site. Morgan Stanley is not responsible for the information contained on the third party web site or your use or inability to use such site. Nor do we guarantee their
accuracy and completeness.
Diversification does not guarantee a profit or protect against a loss.
Sources:
1.
2.
3.
4.
5.
6.
http://en.wikipedia.org/wiki/Eugene_Fama ,
http://www.dfaus.com/library/bios/eugene_fama/
http://www.chicagobooth.edu/faculty/bio.aspx?person_id=12824813568
http://www.usinflationcalculator.com/
http://www.investopedia.com/terms/h/homebias.asp#axzz29l5YUJNn
http://topics.bloomberg.com/smart_strategies_for_etf_investors/
© 2012 Morgan Stanley Smith Barney LLC Member SIPC
Morgan Stanley Wealth Management
1250 Pittsford Victor Road
Building 200, Suite 350
Pittsford, NY 14534
CRC# 572980 11/01/2012