Fama/French Forum

Feb 3, 2010

Q&A: Can Investors Profit from Momentum?

A prominent money management firm has recently launched several mutual funds that seek to exploit the positive momentum effect in stock prices. Why does this well-publicized anomaly persist and under what circumstances can investors expect to profit from it?

EFF/KRF: The momentum anomaly has been observed in most major markets (Japan is the exception). Many academics claim that trading costs will wipe out any benefits of trying to trade actively on momentum. This will now be tested by live funds. The results will be interesting. (Read the full entry)

Jan 22, 2010

Q & A

Q&A: Seeking the Best Inflation Hedge

How do TIPS and one-month Treasury bills compare as inflation hedges?

EFF: TIPs are obviously a great hedge against inflation, but there is still uncertainty about the short-term real return on long-term TIPS. A long-term TIPS is a long-term loan to the Government at a fixed real interest rate. Variation through time in the expected real return that investors require to make this long-term commitment leads to capital gains and losses that affect short-term real returns. (Read the full entry)

Dec 14, 2009

Q & A

Q&A: Are Stocks Safer in the Long Run?

Lubos Pastor and Robert Stambaugh argue that long-horizon stock investors actually face more volatility than short-horizon investors. How should investors interpret this evidence?

KRF: The Pastor-Stambaugh result is driven by uncertainty about the true expected return. The volatility or standard deviation of returns is usually defined as the expected variation relative to the true mean of the process generating returns - as if we knew the true expected return. But, as Pastor and Stambaugh emphasize, we never actually know the true mean. When they include uncertainty about the true mean (as well as uncertainty about other true parameters) in the analysis, they find that long-run returns are indeed more volatile than short-run returns. (Read the full entry)

Dec 8, 2009

Q & A

Q&A: Financial Innovation -- A Blessing or a Curse?

Real economic risk appears to have decreased over time as global economies have become more advanced and diversified. But market risks appear to have increased due to innovative financial instruments with unexpected characteristics. Is financial innovation a good thing?

EFF/KRF: We do not agree with the reading of the facts in this question. We know of no solid evidence that market risks have increased relative to the risks of real economic activity. Market volatility and the volatility of real economic activity were both extremely high in the great depression, and both declined thereafter. During the post WWII period, market volatility tends to increase during recessions, along with (and typically in advance of) the volatility of real economic activity. From 2002 to late 2007 the volatility of real activity was low and market volatility hit all time lows. With the subsequent onset of a severe recession, market volatility increased, along with uncertainty about future real economic activity. (Read the full entry)

Nov 30, 2009

Essays

Luck versus Skill in Mutual Fund Performance

By Eugene F. Fama and Kenneth R. French

Our paper, "Luck versus Skill in the Cross Section of Mutual Fund Returns," examines the performance during 1984-2006 of actively managed US mutual funds that invest primarily in US equities. It is an academic paper with lots of technical detail. The purpose of this white paper is to provide a summary of the results that are relevant for investors. We begin by examining the overall α for aggregate wealth invested in actively managed mutual funds. We then turn to the performance of individual funds.

(Read the full entry)

Nov 17, 2009

Q & A

Q&A: Who Should Hold Long Term Bonds?

Is the absence of a meaningful premium for US long-term bonds relative to short-term bonds evidence of market inefficiency? Does this relation hold in other global bond markets?

EFF: Unfortunately, we need long periods of data to do the relevant tests, and we do not have good long-term data on bond markets outside the U.S. For the U.S. we only have good long-term data (from CRSP) for Government bonds.

Tests on the U.S. data do not indicate that the small average premiums observed in the returns on long-term versus short-term Government bonds are badly out of line with the predictions of asset pricing models. The models do not predict big differences in the returns on long-term and short-term governments, and the observed premiums are statistically consistent with the models. The same is true for the rather small premiums of corporate bond returns over Government bond returns. Is the absence of a meaningful premium for US long-term bonds relative to short-term bonds evidence of market inefficiency? Does this relation hold in other global bond markets? (Read the full entry)

Nov 9, 2009

Q & A

Q&A: Does Your Optimizer Need a Tune-Up?

The realized equity premium for U.S. stocks relative to long-term government bonds has been negative for the 5, 10, 15, 20, and 25-year periods ending in 2008 despite substantially greater standard deviation for stocks. How do I use this information to develop a sensible portfolio based on mean-variance optimization?

EFF: We have emphasized in previous posts that there is substantial uncertainty about the size of the expected equity premium, that is, the true expected return on stocks less the expected return on riskless bonds. Whatever estimate you use, 5, 10, or even 15 years of recent evidence should not change your estimate much. 20 or 25 years of data are more serious, but then there is another issue. (Read the full entry)

Nov 4, 2009

Q & A

Q&A: Is Market Efficiency the Culprit?

Justin Fox ("The Myth of the Rational Market") and many other financial writers claim that much of the blame for the financial meltdown is attributable to a misguided faith in market efficiency that encouraged market participants to accept security prices as the best estimate of value rather than conduct their own investigation. Is this a fair assessment? If so, how should policymakers respond?

EFF: The premise of the Fox book is that our current economic problems are largely due to blind acceptance of the efficient markets hypothesis (EMH), which posits that market prices reflect all available information. The claim is that the world's investors and their advisors in the financial industry bought into this model. Because they ceased to investigate the true value of assets, we have been hit with "bubbles" in asset prices. The most recent is the rise and sharp decline in real estate prices which froze financial markets and led to the worst recession since the Great Depression of the 1930s. (Read the full entry)

Oct 2, 2009

Videos

Fama Lecture: Masters of Finance

From the American Finance Association's "Masters in Finance" video series, Eugene F. Fama presents a brief history of the efficient market theory. The lecture was recorded at the University of Chicago in October 2008 with an introduction by John Cochrane.

From the American Finance Association's "Masters in Finance" video series, Eugene F. Fama presents a brief history of the efficient market theory. (View the video)

Sep 17, 2009

Q & A

Q&A: What if Everybody Indexed?

If a growing percentage of market participants pursued passive investment strategies, at what point would market efficiency break down? Is this a practical concern?

EFF/KRF: This is a complicated question that we address at length in "Disagreement, Tastes, and Asset Prices" (Journal of Financial Economics 2007). The answer depends to some extent on who turns passive. If misinformed and uninformed active investors (who make prices less efficient) turn passive, the efficiency of prices improves. If some informed active investors turn passive, prices tend to become less efficient. But the effect can be small if there is sufficient competition among remaining informed active investors. The answer also depends on the costs of uncovering and evaluating relevant knowable information. If the costs are low, then not much active investing is needed to get efficient prices.

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