The transcript from this week’s MIB: Gene Fama & David Booth, is below.
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VOICE-OVER: This is Masters in Business with Barry Ritholtz on Bloomberg Radio.
RITHOLTZ: This week I was privileged to travel to the University of Chicago to the Booth School of Business where I got to sit down with Eugene Fama, Nobel laureate, Chicago Booth School of Business, Founder of the efficient-market hypothesis, Creator of effectively the three, five and seven Fama-French factor model, basically the Father of Modern Finance — I don’t know how else to describe him — along with his best student David Booth, Co-Founder of Dimensional Funds , the person that the Booth School of Business is named after.
What can I tell you? I flew out to Chicago basically went to the Booth School of Business at the University of Chicago where they were celebrating this relationship that both Fama and Booth have had for literally 50 years. I got to sit down with the two of them for an hour in front of about 500 people in the audience, including a lot of students from the Booth School as well as other notables who were in attendance.
And Fama is notoriously press-shy. He does not do a whole lot of interviews with the media. This was just a delight. I can’t begin to say how just awesome he was.
He’s a provocateur. He likes to say things that are very much contrarian. He’s a little bit — you know, if Fama was on Twitter he would be a troll. He loves to tweet people especially his buddy and fellow Nobel laureate Richard Thaler. He was busting his chops about behavioral finance, basically saying it’s all just pushed back to the efficient-market hypothesis.
David Booth, also very insightful, had a lot of things to say. There’s obviously a tremendous amount of respect between the two of these guys.
I could babble about my experience in Chicago for hours, but rather than do that, why not just say, my conversation with Eugene Fama and David Booth.
(AUDIO CLIP STARTS)
RITHOLTZ: There is so much material to cover. We’re going to keep this to about four hours. We’ll take a break for dinner.
And then we’ll finish up before midnight.
So I really don’t have to introduce either these gentleman, but let me just put a little more flesh on the bones of what — what the dean started with. Obviously, Gene is best known for not only the efficient-market hypothesis but his research on portfolio theory, asset pricing, the Fama-French factor models. He is the 2013 recipient of the Nobel Prize in — in Economics, and I like the sentence that the Nobel Group used, quote, “for — for his work showing,” quote, “stock price movements are impossible to predict in the short-term and that new information affects prices almost immediately, which means markets are efficient.”
David co-founded Dimensional with another University of Chicago alum, Rex Sinquefield in 1981. The firm now employs 1,400 people who help manage $579 billion. Over the 20 years ending in 2018, 85 percent of Dimensional’s equity and fixed income funds beat their benchmark, the rest of the industry just 17 percent, and that’s based on much of the work that Professor Fama did.
So — so let’s jump into the history of both Gene and David and — and see where it goes.
Gene, during your last — I — I feel weird calling you Gene, it really should be Professor Fama, shouldn’t it?
RITHOLTZ: During your last year at Tufts, you worked for Professor Harry Ernst who had a side gig running a stock market forecasting service.
RITHOLTZ: And you did research for him. What sort of work did you do with this stock forecasting research?
FAMA: I was devising schemes to beat the market.
RITHOLTZ: And — and how did that work out?
FAMA: It worked out fine on …
… on the data that I fitted to. It didn’t work out fine on the hold up (ph) sample, never did. So that was a lesson that data judging can turn up things are not really there.
RITHOLTZ: And how did that research into forecasting the stock market impact your thinking about whether or not the market could be beaten?
FAMA: Well, when I came here to Chicago, research on asset prices had begun to get going in a really serious way. And many people were interested in the question of how well stock price is adjusted to new information. To put in context, I always say it — it started because of computers.
Before 1960, it really didn’t have a serious computer to do data analysis on. And with the coming of computers, statisticians, economists were — they had a new toy to — to play with and stock — stock prices were easily available. So that was one of the first things they started to study.
And then immediately, the economists said, “Well, how do we expect prices to behave if the world was working properly?” in other words, if markets were efficient. They weren’t using that term, but that’s what they were after. And there were all kinds of theories proposed that had lots of shortcomings to them and a little bit of time when it came to the efficient-markets hypothesis.
RITHOLTZ: And you were in your senior year at Tufts, you had applied here but you never …
… heard back from the school.
RITHOLTZ: Is this an urban legend or is this true?
FAMA: No, it’s true.
RITHOLTZ: So — so what happened?
FAMA: I called — I called and the Dean of Students Jeff Metcalf answered. That wouldn’t happen today. The school is so much bigger. The Dean of Students doesn’t even have a telephone. Way too important for that, right.
So he answered the phone. We chatted for a while and he said, “Well, I hate to tell you, but we don’t have any record of your application. So what kind of grades do you have at Tufts?” And I said, “Pretty much all As.” He said, “Well, we have a scholarship for someone from Tufts. Do you want it?”
You know, that’s how I — that’s how I ended up with the University of Chicago.
RITHOLTZ: So — so you come here as a student. You’re — you’re finishing your work. Eventually, Merton Miller says to you, “Hey, do you want to stick around and keep doing the sort of research you’re doing?” Is that how you became a — a professor here?
FAMA: Yeah. I was — I had offers at some other places, but lots of the places turned me down. They said it was too Chicago (inaudible).
I don’t know what that meant actually, but (inaudible).
RITHOLTZ: These guys know exactly what that means.
FAMA: Right. But it was very rare to hire somebody from your own Ph.D. program onto the faculty. They (inaudible) do it one or two before that.
RITHOLTZ: So David, you had a somewhat different experience. You grow up in Kansas, you get a B.A. in Economics and a masters from the University of Kansas. What made you decide to come to Chicago?
BOOTH: Well, I did a little bit of reading in finance. And my — I had a finance professor there that got his Ph.D. here, and he said finance is exploding, really emerging as a — an academic discipline. It’s really one of the — the epicenters that’s clearly Chicago. And so I thought, “Well, yeah, it should be fun. Maybe I’d even be a professor,” so I applied here and started to study. I took Gene’s class, my very first class.
RITHOLTZ: And is — was the Dean correct? Was that literally 50 years ago?
BOOTH: Yeah, 50 years ago this fall.
BOOTH: It was — yeah, it was the first year that Chicago had a football team in 34 years, you know?
RITHOLTZ: And you had written about your experience taking a class with Gene. You called it life-changing and — and transformative. In what ways was it life-changing?
BOOTH: Well, life-changing, it led to a career. I mean, I can’t have much of a bigger change than that, but it’s life-changing. And then I think all — everybody here probably would like to think of themselves as having a public purpose. At the end of it all, when you get to be my age, you want to look back and think somehow the world was better off for your having been here.
And so these ideas that were coming out, you know, the essence of efficient markets was already well-developed. He had already coined the term. And you see this is enormous useful. If you look at the — the way money was managed 50 years ago, people are getting ripped off. I mean, fees are way too high, you know, the commissions were fixed by the government at — about 10 times what they are today and …
RITHOLTZ: Well …
BOOTH: … so forth.
RITHOLTZ: It’s free today so …
… it’s a lot more than …
RITHOLTZ: … 10x.
BOOTH: Yeah, yeah, yeah. So it’s — I think there was a spirit of — that we can improve people’s lives, you know, a real purpose to all of this. You know, Gene, more on the — the research side and I’ve thought my role in all of this would be more on the application of the ideas.
RITHOLTZ: So you become Gene’s teaching assistant. How did that come about?
FAMA: I always — I always pick the best student in the class in the previous year to be the teaching assistant next student.
RITHOLTZ: So good student.
FAMA: Yeah. He’s the best of the class.
BOOTH: You don’t have to laugh at that, I mean, it’s the truth.
RITHOLTZ: So best student, Professor Fama’s teaching assistant, why not a career in academia?
BOOTH: Well, first off, I realized I could never compete with Gene. I mean …
… when you’re at the top of the mountain and — but it’s really something — it caused me to reflect and, you know, really internally what — what am I about? What do I enjoy?
And I — I — I just saw this as a great opportunity to go out to apply all these ideas. People were developing. Every new paper coming out was a landmark paper. It was — it was all brand new stuff and none of it was being applied.
RITHOLTZ: So we’re going to come back to the application very shortly, but you mentioned that all these new groundbreaking papers were coming out.
Professor Fama, your doctoral thesis in 1964 was the behavior of stock market prices, and this sentence jumps right off the page. Quote, “Chart reading, though perhaps an interesting pastime, is of no real value to the stock market investor.” So this gets published in the Journal of Business in 1965, what sort of pushback do you get to the general concept that charts are of no use, past market walk is of no future predictability to what happens going forward?
FAMA: Well, you got a lot — a lot of pushback from the professionals. The academics looked at the data and looked at what people were saying, what they were showing and adopted it right away. I mean, there was no pushback among the academics really.
BOOTH: It’s really the beginning of — I mean, if you had to summarize really the impact of all this is what was going on in Chicago then really changed the way people think about investing, and that’s really been the theme. Gene has changed the way people think about investing more than anybody.
RITHOLTZ: That’s — that’s the pre and post line, pre Fama and post Fama.
RITHOLTZ: There’s a sea change …
FAMA: Wait a minute, I don’t like the post Fama business.
RITHOLTZ: … meaning — meaning post publication …
RITHOLTZ: … of your work.
BOOTH: Yeah, yeah, I get it, right.
FAMA: …just didn’t worked out.
RITHOLTZ: So — so we not only have your doctoral thesis, we have the Efficient Market paper, we have the Fama-French three-factor paper. There are a number of very, very influential papers that David, if I’m hearing you correctly, you’re saying that changed the firmaments of finance forever.
BOOTH: Changed it forever and for the better. I mean, I get to — particularly in 2019, there’s — among students, there’s this kind of antipathy towards finance and economics, you know. And they don’t realize how much finance has changed for the better. People’s lives have been improved by these ideas in this research — lower fees, better risk control and so forth.
RITHOLTZ: So — so let’s — let’s compare then and now a little more specifically and we’ll start by talking efficient markets. Back in the days when active managers were dominant, inefficiencies could still be easily found as could two percent fees. Professionals didn’t believe markets were efficient. They thought they were kind of sort of eventually efficient. I doubt many of them would say that today. What do you think has changed to bring so many people over to the efficient market theory?
FAMA: Well, the accumulation of — of performance evidence. So back then there was — there was no real evidence on how these people did, and one of the first papers was like Jensen’s thesis here, which studied mutual funds for the previous 25 years and showed that basically they weren’t beating the market.
Now we know on hindsight that, in fact, that has to be true that active management is a zero-sum game before cost because they don’t — they can’t win from the passive managers because the best of people hold cap weight portfolios. They don’t — they don’t overweight and underweight in response to what the active people do. So if — anybody underweighting and overweighting, there has to be another act of magic on the other side doing the opposite, which means if one wins, the other loses.
You know, some of those is zero before costs. The (inaudible) …
BOOTH: You have the (inaudible) has a fine way of …
FAMA: That (inaudible) …
FAMA: … the arithmetic of active management. He calls it the arithmetic because it is arithmetic. It’s not a proposition. It has to be true.
RITHOLTZ: For every winner, there’s an offset in losing.
RITHOLTZ: So what about technology? How does that impact how fast information makes its way into prices?
FAMA: Well, it should make it better. But, you know, the truth is prices are so volatile, markets have always looked really efficient. They don’t look any more efficient than they — than they ever have with the introduction of our all the new technology.
RITHOLTZ: So …
FAMA: So information is — is spread much more quickly now than it was 50 years ago because you have so many sources, and it’s so quick. But you can’t really see in the data that that’s had a quantum effect on the adjustment of prices to information.
RITHOLTZ: So we may not be able to see it explicitly in the data, but when we look at things like hedge fund performance,, they did very well before the financial crisis. Since then, not as well, we look at the money flows away from expensive active towards inexpensive passive. It sounds like lots of investors are voting with their dollars that, hey, the market is efficient and we can’t beat it. Doesn’t it seem like technology is driving some of that because there used to be information asymmetries. There used to be inefficiencies that a savvy manager might have been able to find. It sounds like it’s even harder to find those inefficiencies today than 30 years ago.
FAMA: You have better information than I do because …
… it’s — it’s …
RITHOLTZ: You’re saying it’s the same.
FAMA: … always look good.
RITHOLTZ: It’s always been that way.
FAMA: It’s always been zero-sum game.
BOOTH: You know, I’ve been in the business now almost 50 years, and every year people say next year is going to be the stock pickers — going to be the stock pickers market. What Gene is saying is it’s …
FAMA: It can be.
BOOTH: … arithmetically impossible.
RITHOLTZ: So — so let’s talk a little bit about index funds. Gene, you introduced David when he is finishing his MBA and wants to go out into the world of work to John McGowan over at Wells Fargo where they were developing as an institutional product the first index fund. What made you think that that was a good fit for — for David?
FAMA: Oh well, Mac McGowan (ph) who was in charge of the Wells Fargo unit came to all the seminars we did here for business people. We did them twice a year. The Center for Research and Securities Prices were doing seminars for interested business people. And Mac (ph) came to all of them and he seemed very, you know, into the new stuff.
And so when it came time that David said, “I see what you do, but I don’t want to do it …
RITHOLTZ: As an academic.
FAMA: And so I called Mac (ph) and said I have a really good student here if you’ve got a place for him, and he did.
RITHOLTZ: So what was your experience like at Wells Fargo working on that index fund?
BOOTH: Well, that was a terrific experience, great exposure. I learned the importance of client work. I mean, investment business is part technology or investment science, and it’s part client work. And as I’ve told Gene, you know, I studied finance for two years, I’ve been studying client work for the last 48, you know, and that was — we were so naïve about dealing with clients and what they would be interested in, and we were so pumped up, jazzed up about the ideas. Somehow we missed the mark, and actually my group got — it was unsuccessful, we got shut down. But there were other parts of the bank kept on going. And now that little project we started to end up as — through various hands is now a big part of Blackrock.
RITHOLTZ: So — so let’s — that’s right, you eventually ended up going to Barclays and then BlackRock buys them and now iShares.
RITHOLTZ: I think they’re coming up on $6 or $7 trillion.
BOOTH: Yeah, right.
RITHOLTZ: Not too — not to shabby. But let’s talk about the application of Gene’s theories to the practice of working with clients. Post Wells Fargo, you decide open the small micro-cap fund out of your second bedroom apartment in Brooklyn. Tell us how you applied Professor Fama’s research to that microcap fund.
BOOTH: Well, the first thing is we decided not to have run the portfolio like an index fund even though, at first, we call it an index fund because it’s very similar to indexing with the final step being that we don’t trade market on close like many index funds do. And what that means is we were — we would be trading stocks throughout the day.
Well, that created a lot of skepticism, particularly among academics because you’re going to the marketplace, you know you don’t have any undiscounted information. People on the other side of your trade — largely institutions — think they know a lot about the stock. You know, why won’t they just rip your eyes out when you’re trading. That’s a — that’s a quite legitimate question.
RITHOLTZ: So what’s the answer?
BOOTH: Well, that means that the answer is there a lot of things you can do to use the energy of markets and the power of markets to your advantage. And it turns out, for example, if we want to buy a stock, let’s say, and if an institution wants to sell it, their anxiety is greater than ours so we can use that — their interest in trying to do a quick trade to our advantage and — and protect ourselves.
And there’s, you know, plenty of — of information out floating out about the stock that you can use to protect yourself, but that wasn’t known back then. It was just — we had a belief in markets, a belief in — on how they work based on what we studied here and said, “Look, we think we can go out and trade these stocks and not — not get killed.”
FAMA: That there were two — two theses done here on small stock returns, and most of the academics said, “Well, it looks good in terms of the crisped historical data but, in fact, if you try to trade it, you’re going to get swamped by trading costs.” And that was the so-called market microstructured stuff. And then we figured out with what we found out what Dimensional was, no, he really didn’t have — have to pay those big bid-ask spreads that you were seeing. He could go few as a patient (ph) trade or you could do better with — with the prices, so we could deliver the small stock premium.
RITHOLTZ: But previous to that, people weren’t able to capture the premium?
FAMA: Academics didn’t believe …
RITHOLTZ: The spreads.
FAMA: What — what the academics learned was the microstructure stuff was garbage basically. They didn’t really understand and so …
BOOTH: You know, interesting what we learned about clients along the way, which was — see in 1981, big — our — our initial clients were all large — largest pension funds essentially, insurance companies around the world and they weren’t opening the stocks of small companies. So really the pitch that we got into all this stuff, but we hadn’t even easier argument, which was, look, you ought to hold stocks of large companies and small, and you’re not holding small so we’ll give you access to small. So that was the — really the sales pitch that put us on the map.
RITHOLTZ: So that sales pitch starts to take off and Dimensional operating out of your apartment gets bigger. There’s kind of an urban legend that you called New York Telephone to have them add six phone lines and they refused. They thought you were running a bookie joint.
RITHOLTZ: Is that remotely true?
BOOTH: This was back the — kind of it the bottom of Brooklyn Heights, bottom of its history. It’s — so we started on a shoestring and we ran portfolio — I was the first portfolio manager running out of my spare bedroom, so I knew we needed more phone lines. So I called up to tell New York Telephone, which was a telephone company at the time. I said I need, you know, some telephone lines, you know, six or eight or whatever. And they — they thought I was a bookie, so they wouldn’t give me the light.
So I had to call up the treasurer of New York Tel and say, “You know, can you send some people down here and give me some telephone lines?” And they went around the whole block and found that there were six lines available …
… and the whole block that — based on their equipment. And they said, OK, you can have those six lines, and that’s how we got started.
RITHOLTZ: And the punch line is he becomes a client.
BOOTH: Yeah, yeah, right. New York Tel was going to be the client, yeah.
RITHOLTZ: So — so from — from day one, Gene is a board member of Dimensional Funds from the day it launches?
BOOTH: Well, even before, I mean, this …
BOOTH: … we got the idea to start the firm. My first call was to Gene saying, “Look, you know, it’s been 10 years since I was in school. We — there’s been a lot of research. I know we — we need — we needed to have access to, you know, new research and thinking, and would you be on the, you know, one of the founders and — and — and be our, you know, our eyes in terms of research? And he agreed to do that right away.
RITHOLTZ: Who — who else did you recruit from GSB?
BOOTH: Well, eventually we found out we had to have — we wanted to create a mutual fund, and a mutual fund has to have an independent board of directors. So Rex and I went over the Business School, walked into Merton Miller’s office. They still Miller-Modigliani here. I’ll tell you right here.
Yeah, OK. So Merton was there. We said, you know, yada yada, a small company fund need independent directors. And Martin said, “Oh, sure,” and walked out the door and down the hall, and Myron Scholes was coming out of his office. I said, “Myron …
… yada yada. See, to Gene point, this business school was a lot smaller then. And having been to the Ph.D. program you kind of got to know the faculty pretty well. So Myron agreed to join and, you know, so on and so forth. So, in fact, until recently, all the independent directors of the — of the mutual fund — our mutual fund then have taught at Chicago.
RITHOLTZ: So …
FAMA: Well, his — his business partner Rex Sinquefield was in my class as well. He was really the first one to put out an index fund, wasn’t he?
BOOTH: No, no, it was …
FAMA: Security index fund.
BOOTH: … your first S&P 500 index fund.
FAMA: OK, was it? OK.
BOOTH: But Rex — actually, that was when I was his teaching assistant …
BOOTH: … that he took Gene’s class, and Rex was always one of these pain in the neck as a teaching assistant students because he was interested in everything, you know, and so …
RITHOLTZ: So — so, Gene, you move pretty easily back and forth between academic theory and real-world application of — of …
FAMA: Yeah, true.
RITHOLTZ: … the theories.
Not a lot of people were able to bridge that gap between academics and real …
FAMA: Yeah. Well, I hadn’t — I hadn’t been able to bridge it either until Dimensional came along.
RITHOLTZ: But here it is, it’s 40 years later and you seem to continue to be …
FAMA: Right, because he — the reason I couldn’t is because, one, it’s hard to shut me up, I don’t take a party line too — too easily. And he — he didn’t ever — although he and Rex never said, “Would you please do this?” What they said was, “You do what you do and we’ll figure out if we can use any of it.” And that fits in with the way I work so.
BOOTH: Frequently he would come in and say, look, get — get ready to make a presentation with our clients and go, “You know, I know your clients don’t want to hear this.” I go, “Look, Gene, you know, say what’s on your mind. Spin controls my department, you know.”
RITHOLTZ: And that seemed to have worked out.
BOOTH: Yeah, yeah.
RITHOLTZ: So what was your involvement with the Investment Committee in — in the early days of Dimensional? Were you participating actively in it? Were you managing it? What — what were you doing?
FAMA: Well, I was doing this back and forth with the research stuff, but then they started a — a fixed income fund based on fixed income research in the 70’s. And they said, “Do you want to come in and trade it for a day?” And I said, “Sure, I would want to trade anything.”
So I went in and, “How much money do we have? We have $10 million from somebody.”
FAMA: And I managed to buy $20 million of bonds.
And that was a big problem actually.
RITHOLTZ: So wait, so wait. Gene Fama …
RITHOLTZ: … day trader.
RITHOLTZ: I just want to make sure that I understand.
BOOTH: Yeah, we had a — that was the last day we’re letting him up there.
FAMA: But I — I couldn’t see the problem.
How can you complain about getting …
RITHOLTZ: It’s a good price.
FAMA: … what you have.
FAMA: That’s right.
RITHOLTZ: So you introduce the Fama-French paper on value in 1992, Dimensional Funds introduces a U.S. large value and U.S. small value in ’93. Another Fama-French paper leads to international value coming out in 1994. That paper won a Graham and Dodd Award of Excellence. Was there anyone else trying to applying this sort of academic research to either investing theory or the creation of investable products?
BOOTH: On the market, there are always kind of departments of big banks, the people who are kind of playing around with it, but we were the only ones willing to stand up and say this is what we believe and this is what we think you ought to do. Now there — we have all the quant managers out there, we got tons of people out there, you know, trying to apply the same data.
Back then we basically were it. In fact, I often go around and show people 30-year track record on the various funds. And I go — you know, we had a lot of competition back then, but they don’t seem — don’t seem to have a 30-year track record other than that, you know.
RITHOLTZ: They — they did not survive long enough to …
BOOTH: They didn’t survive, yeah.
RITHOLTZ: So let me fast forward a couple of decades to the mid-2000s. In 2008, David Booth made the largest donation ever given to a business school, which has been called a “transformational gift.” Tell us about your thinking what made you decide in the middle of the financial crisis to say, “I know, I want to make a donation to my alma mater.”
BOOTH: Well, it was kind of ties in on the story I’ve talked about earlier. I mean, what — it got to be the stage where it was time to pay back. And I mean, I wouldn’t have been anywhere without Chicago, so I said I want to give a big chunk of what I have and …
RITHOLTZ: This was a mix of stocks and cash. Is that correct?
BOOTH: It was — actually, I didn’t have a lot of cash at that time. It was …
… because we just recently started to accumulate money getting big enough to — but I had stock in the firm, and so I gave them basically ownership of a — a big chunk of the — of the stock that I had. And they were willing to take a bet on that, and it turned out to be a good bet.
RITHOLTZ: And that — that comes with a dividend, which continues …
RITHOLTZ: … to pay its way to — to Booth. Were you at all concerned that you were right in the middle of a financial crisis, giving ownership of a financial firm? A lot of firms did not make it through the financial crisis?
BOOTH: Yeah, maybe it ties in with the earlier question about — what I learn from here about markets and how they work. And you have to kind of keep — in the depth of the financial crisis, you kind of have to keep reminding people, you know, markets are where buyers and sellers come together. And in a voluntary transaction, both sides of the trade have to feel like they’d have a good — they got a good deal or they don’t — they don’t trade.
So, you know, there’s a lot of trading volume activity and a lot of well-known investor is investing. And it’s just, you know, one of those — those comfortable — those markets were functioning the way they — they ought to function. Sometimes they go up, sometimes they go down.
RITHOLTZ: Gene, how did David’s gift impact the Graduate School of Business?
FAMA: Because it was a big — a lot of cash flow that was not there beforehand so …
… it gave rise to lots of research centers, I think, and it made everybody feel as if the future was more or less assured. And the University also got a pretty good take out of itself as they always do but …
RITHOLTZ: So, David, you tell a — a charming story about sitting with the Dean and you — was it your intention for this originally to be a naming gift? They seem to have brought that up to you. Can you …
BOOTH: Yeah, right. You know, I said I wanted — oh, this is for the reasons I outlined, I wanted to — to make a gift, a big part of what I have. And so this is what I want to do. And the Dean Ted Snyder, at the time, said, “Gosh, we were looking to have a naming gift for the business school. This is a lot better deal than that, what we’re looking for.”
So we’ll name the school after you. OK, whatever, you know.
RITHOLTZ: So since then the school has continued to grow in — in both reputation, and number of students and the offerings here. And then fast-forward five years after that, Gene gets a phone call from Sweden. Let’s talk a little bit about that. What was your experience like? Did the phone call manage to reach you? Tell us — tell us what that was like.
FAMA: I think — I think they call it …
RITHOLTZ: Early in the morning, right?
FAMA: You know, one o’clock Stockholm time, which is really early in the morning. Here I think it’s about five or six o’clock. So I know — you never expect to get it because a lot of people could qualify to — to get it. When you get it, somehow — the — the people here somehow had a guess or whatever, I don’t know why, because there were newspaper people at my door 10 — 10 minutes later after the — after the call. And they wanted to come in my house.
I said no way.
BOOTH: But you’re on your way to class.
FAMA: Well, I had a class that morning and …
RITHOLTZ: You don’t — you don’t get a special dispensation when you’re a Nobel Prize, you skip class?
FAMA: Well, we could — we could, but I had never missed a class in all the years I’ve been teaching.
RITHOLTZ: In 50 years.
FAMA: Yeah, and I — I wasn’t going to start now, so — and I wasn’t going to let anybody in because the kids in the class were paying a lot of money to take that course.
RITHOLTZ: So …
FAMA: No way I wanted people from the other side disturbing it.
RITHOLTZ: So, David, you ended up going to Stockholm with Gene. What was that experience like?
BOOTH: Oh, it’s — well, of course, being Chicago-trained, I’ve been to the ceremony before. I went with Myron and Bob Merton got their Nobel. So, you know, it’s — you’re kind of used to this if you …
RITHOLTZ: Third time is a charm.
BOOTH: So …
RITHOLTZ: Third time is a charm, is that (inaudible)?
BOOTH: Yes. So the — so I — I said to Gene, give me a night to organize something special. So I talked to — ABBA has a museum in Stockholm. They didn’t just open. And I talked them into renting me out the museum for the evening.
So Gene, you know, he has four kids and, at that time, about eight grandkids, and they’re all big music fans. And so they have a museum, has a lot of things you can do to have fun. And one of them is a big stage with a scrim on it and with the four ABBA musicians singing and with a microphone right in the middle. And so you — it looks like you’re singing with them.
And so I look — so this went on, they were — the kids — the kids went wild. I looked over at Gene. I can — and Sally, and I could see that they were — they were having fun. So I made it special for me.
RITHOLTZ: So the whole thing some people have described as surreal, what was your — your experience?
FAMA: It is surreal. The day of — the day after so they had a big event here at the school, really a big event, I mean, with the news and everything, and while the circles around the building were all full of students. And the next day, the Nobel people have a camera committee and they’re following me across the Harper Center, the — the big atrium in the middle, and students are working along the sides. And we walked down the middle; nobody looks up.
So we get to the other side. And the television guy says nobody looked up. And I said, “This is the University of Chicago. If they had to look up every time a Nobel Prize went to walk by, they get nothing done.”
RITHOLTZ: And — and to show you how true that is, David Booth and Gene and I get in an elevator on four to come down here, and a student gets in wearing headphones turns around, doesn’t say a word to either of you, and the four of us rode down in silence. He was completely oblivious to who was in the elevator with him.
So I’m always fascinated by that sort of stuff. So — so let’s — let’s talk a little bit some other things that you’ve written about and — and the two of you have applied. One of the quotes of Professor Fama’s that I enjoy is, quote, “Why is anyone even reading the Wall Street Research?” unquote. So I have to ask you why do people read Wall Street Research?
FAMA: I don’t know. It’s …
… it’s business-based pornography basically.
RITHOLTZ: Business-based pornography.
FAMA: Yeah, it’s — it’s not the real thing.
RITHOLTZ: It’s not the real thing, OK.
RITHOLTZ: So let’s talk a little about value. I’m going to try and reel this back.
FAMA: Yeah, right, (inaudible).
RITHOLTZ: Let’s talk about value and growth. Value has a tendency to go through these longer periods where growth is beating it. And over the past decade, it’s been — if you weren’t in big cap U.S. growth, you were underperforming. Everything has been the S&P 500 when we look at emerging markets, we look at small capital, we look at value. Heaven forbid, you’re an emerging markets small cap value. It’s been terrible. What sort of lessons should investors take from this extended period of growth — growth beating value?
FAMA: Well, the — the person I want to ask is is that you did.
RITHOLTZ: OK, let’s ask.
FAMA: So Ken and I actually were writing a paper on this at the moment. But the bottom line is there’s so much volatility in these premiums that you can’t tell if the premium is changed or not. It may have changed, it may not. You just can’t tell. It’s well within the range of chance the experience that the — the poor return experience is well within the range of chance over the time that — that it’s a period. So you really can’t say anything.
RITHOLTZ: So — so there have been other periods of time where value was done poorly. I remember hearing in ’98, ‘99 this value investor was washed up, this guy …
RITHOLTZ: … named Warren Buffett, he doesn’t know what he’s doing. And typically when you hear that, it’s usually at the end — towards the end of that period of underperformance. You’re suggesting we won’t know for some period of time if the value premium is gone or if it’s just a regular cyclical underperformance.
FAMA: Well, I don’t think there are real cycles to it. I think it’s just kind of random that you go through good and bad periods and, you know, you can’t recognize them except after the fact.
FAMA: You can’t really predict them. We’ve — we’ve tried tests — we tried predictive tests and they — they have marginal value, nothing worth, you know, focusing — focusing on. So basically, you’re stuck with the volatility of equity returns. They don’t like to say very much about what’s happened to expected returns going forward.
RITHOLTZ: And — and David, we’ve seen a huge proliferation of various factor funds not just the three-factor or the five-factor or the seven-factor model, there are now hundreds identified. What — what does this mean for investors? Has the proliferation of all these new factors been good for investors or is it a non-event?
BOOTH: Well, I mean, I think unbalance has been overstated whatever — whatever it is. The — you know, I think, you know, research has identified, you know, factors that seem to explain differences in average returns, but it can’t be hundreds of factors. I mean, they got to — they’re probably — at the end of the day, there are probably a few factors. Gene and Ken, one of the things they try to do is instead of trying to identify more and more factors is take the researches out there …
FAMA: And can shrink it.
BOOTH: … and that’s a downtime, simpler, you know, more …
RITHOLTZ: Factors that matter.
BOOTH: Factors that matter.
FAMA: Lots of these things are just different manifestations of the same thing.
BOOTH: Give us an example.
FAMA: So value can be measured in many different ways. I can use the book-to-market ratio, I can use it cash flow enterprise, I can use lots of different variables to identify what is basically this — the same thing. And there are thousands of finance professors out there who all want to get tenure. They have to publish to do that, so they’re all just kind of switching through the data, finding stuff that may be there only on a chance basis, and it won’t be there out of sample. So there’s lots of work being done, and that remains to be done on what we call robustness. How does this stand up when I have new data.
So we — we’ve always been into robustness in the sense that when we found in the ‘92 paper, we went back and collected the data back that we — that data started in — in ’63, we then went back and collected the data back to 26 to look on a sample, then we looked at the international data to look on a sample. It’s pretty much the same thing everywhere.
Now we’ve had a bad period of this. But relative to all of that, it doesn’t look that — it doesn’t look that serious.
RITHOLTZ: And — and I have to ask you a question about behavioral economics. We’re here in Chicago where we could sort of call it the birthplace of behavioral finance. What do you think about that area and what’s your involvement with it?
FAMA: Well, my good friend Richard Thaler who is the — the king of the behavioral finance people.
RITHOLTZ: And another Nobel laureate …
RITHOLTZ: … that no one notices.
FAMA: I tease them and say, “I’m the most important person in behavioral finance.”
RITHOLTZ: You are.
FAMA: I am.
RITHOLTZ: Why is that?
FAMA: Because most of the behavioral finance is just the criticism of efficient markets.
So without me, what do they got?
RITHOLTZ: And — and you and — and Dick Thaler are golf partners …
RITHOLTZ: … aren’t you?
RITHOLTZ: So do you argue across 18 holes or …
FAMA: No, the reality is we agree on the facts, we disagree on the interpretation.
FAMA: So, for example, he thinks the value premium is the result of people’s misperceptions of what accounting information and other information looks like. It’s all based on misinterpretation of information. Now if you believe that then you think it should go away because it’s possible to teach people that they have these — these biases. So professional managers should be able to get — get past them.
RITHOLTZ: But they still have emotional reactions that sometimes …
FAMA: Right, right, right.
RITHOLTZ: … they can’t get by.
FAMA: Well, that — that’s the thing about behavioral economics. What — what their studies seem to show is people don’t learn from experience. If you’re stupid, you’re repeatedly stupid well, you don’t …
… learn. And most people are stupid, I mean, that’s the whole — that’s the proposition.
RITHOLTZ: Someone has to be on the wrong side of that trade. You said it’s a zero-sum, right?
RITHOLTZ: So — so you guys agree more than you — than you might realize.
FAMA: We agree on the facts.
RITHOLTZ: Yeah, but not the interpretation.
RITHOLTZ: So …
FAMA: But there is no behavioral finance.
RITHOLTZ: Wait, say that again?
FAMA: There is no behavioral finance.
RITHOLTZ: There’s no such …
FAMA: It is all just the criticism of efficient markets.
FAMA: With no evidence.
RITHOLTZ: Is Dick here?
I think he would disagree with that. So let’s …
FAMA: I’m not so sure because when I — when I put the challenge to him, 20 years ago I wrote a paper that said, “OK, now you’ve been criticizing us for the last whatever. It’s time for you to come up with a theory that we can actually test and see if it works or not.”
RITHOLTZ: And what was his response?
FAMA: So — we’re still waiting.
BOOTH: Well, actually you presented that paper at a — at a — at UCLA yet …
BOOTH: … and Gene walks in and says, “On the way over, I was thinking about breaking my leg or something so I could catch some sympathy here.”
RITHOLTZ: And to be fair, when Thaler won the Nobel Prize, he admitted his plan was to spend the money as irrationally as possible, so even he …
… even he agrees with you on that.
I wanted to ask about some of your comments on beta. In 1993, you said beta is dead. Do you still believe beta is dead?
FAMA: Well, the evidence basically says that the relation between average return and beta is too flat to be explained by the capital asset pricing model. That’s a real shame because that model is so simple. If it were true, it would be really — really — make life a lot simpler in — in many ways, but it just has never worked very well.
RITHOLTZ: All right. So what we’re going to do now I just have many more questions, but this thing is lighting up and we have questions from the audience. So I’m going to – I’m going to ask a few from this and see — see where we go from here.
Let’s talk about your views on the future of active management. Where do you see the industry going in 10 years? And this is for both of you.
FAMA: Active management.
RITHOLTZ: Active management.
FAMA: Well, it’s been shrinking really slowly. So when Ken did his American Finance Association president …
RITHOLTZ: Ken French.
FAMA: French, did his president speech, he — what he said was — one of the things he said was, “We’re going from zero to 20 percent,” and I think it was about 40 years at that time, maybe a little more. And since then we’ve gone to like, I think, it’s up to 30 or 40 now that’s passively managed. So that’s permeated very slowly through the — from the profession. What — where it’ll go from there, we’ll see.
RITHOLTZ: And — and some people have made the argument you have to separate active from expensive. Low-cost active is attractive. Obviously, this is a key tenant at Dimensional Funds. How much of the move away from active has really been away from expensive?
BOOTH: I think a big part of it. And, in fact, a lot of the move to indexing is through ETFs, and a lot of the — a lot of that is just a new version active management or managers say, look, I don’t think I can pick individual stocks, but I can time sectors of the market, so let me buy a — buy ETFs. So it’s really kind of confusing as to, you know, what the trend has been in active management. But I — I think active managers are resourceful, have always come up with new ideas of trying to entice people with — with magic.
RITHOLTZ: With magic. So the pushback against efficient market, we always see this argument. Berkshire Hathaway had strong returns in its early years as a result of Warren Buffett’s skill and security selection. How — given Professor Fama’s comments on market efficiency, how can this early success be explained?
FAMA: So you take — you have probably 100,000 people picking stocks, right …
FAMA: … over a period of time, then you pick out the — the one who does the best and — and then pick that to skill. The problem is if I have 100,000 people picking, what’s the probability that one of them will look extraordinary purely on a chance basis?
RITHOLTZ: You’ll — you’ll always have some outliers that look extraordinary.
FAMA: You’ll get a big outlier in that — that experiment, but that’s the way the — the newspaper accounts run. They take — they look after the fact and they pick out the winners. So every year, for example, they pick out the best performers of the last five, 10 years and you look at the following period, no, no, no correlation between past success.
RITHOLTZ: And, in fact, we’ve seen the Morning Star manager of the year tends to significantly underperform in the decade once they win manager of the decade.
FAMA: Well, that would surprise me, too. I would think they’d just be random after that.
RITHOLTZ: No — no persistency …
RITHOLTZ: … in fact, negative persistency.
FAMA: Right. We’ve had theses on that subject, you know, how much persistence is there on performance? The answer is basically zero.
RITHOLTZ: Zero. And I — I have …
FAMA: Well, the best predictor of future performance is fees and expenses.
RITHOLTZ: That — you know, it’s ironic that came out …
FAMA: Wrong side.
RITHOLTZ: … of Morningstar …
RITHOLTZ: … that did a big study, and they sell their Morningstar rating, and it turned out ignore everything else, just pick the cheapest fund. Pretty — pretty astonishing.
FAMA: Right. Well, they came out — I think they came out and said — came out and said there’s no relation between future performance and the way we rank things. Isn’t that the question that it comes after that?
RITHOLTZ: So — so one — one of the questions that is asked by the room, if the market becomes truly efficient one day, what happens to all of the management firms? That question assumes that markets aren’t truly efficient today. How do you respond to that?
FAMA: Well, what’s the evidence? No, I mean, I don’t think it’s — I think all of it is wrong, so it’s — there will still be a management business, it just will have very little activity. So the — you have to have some active investors to make price — prices efficient.
The — the problem is you don’t expect them to be professional managers because the logic of being a good investor is that you should get the returns.
FAMA: You don’t hand them back to the people. You take them back in higher fees. You know, that’s the human capital activity is picking stocks or whatever your investment management. So if you have real skills, you’ll be charging. It should all go — all the return should go to you, not to your clients.
RITHOLTZ: And — and this is for both of you. What sort of opportunity for outperformance do you see in private markets given that information in that space is so much more opaque …
RITHOLTZ: … than in public markets?
FAMA: The problem is there are lots of good people studying that, but they’re hamstrung by the — the lack of good data on people who live and people who die. The fund — you know, the managers who live and the managers who die.
RITHOLTZ: What’s self-reported, it’s not like mutual funds where …
FAMA: So self-reported, right.
RITHOLTZ: … they have to report it.
FAMA: Right, so you get — you get ahead — you get a very — kind of bias set of data on that. But, you know, it’s kind of — it depends on what end of that business you go to. If you’re looking at managers who actually run the companies that they buy, they may actually be able to add value, but it’s management value. It’s not stock picking value.
If they — you’re picking companies that have — have a good idea but are poorly run, probably you can have a lot of value added in that case. But again, it should go to the guys doing it and that’s (inaudible) there is. That’s the — that’s the downside of that.
RITHOLTZ: They’re the ones who take all the profits out of it …
FAMA: Well, I mean, that’s …
RITHOLTZ: … not the investors.
FAMA: … that’s the logic of human capital, right?
RITHOLTZ: And we didn’t get to a question before I — I have to ask about bubbles, and this goes back to behavioural …
FAMA: That’s a square, by the way, but …
RITHOLTZ: OK. So I’m going to have to bleep out the word “bubbles,” but …
FAMA: What do you mean by a bubble?
RITHOLTZ: OK. So folks like Thalor and Shiller would describe a bubble as a period of excessive market enthusiasm that leads prices to far outstrip their fundamental valuation.
FAMA: So what — what’s the testable proposition there though?
RITHOLTZ: I don’t know.
FAMA: Can you — yeah, well, the way I interpret it is you must be able to predict the end of it. A bubble has — it’ll be something with a predictable ending.
RITHOLTZ: So it has to be measurable by a predefined set …
FAMA: Right, right.
RITHOLTZ: … of parameters …
RITHOLTZ: … and you should be able to identify the …
FAMA: Right, right.
RITHOLTZ: … end of it.
RITHOLTZ: So if we were to say …
FAMA: We fail the test every time on that one.
RITHOLTZ: Fails the test.
FAMA: Right. I mean, you can’t — people can’t identify a bubble that way.
RITHOLTZ: Until after the fact?
FAMA: After the fact, it’s — it’s easy but there’s this famous theory around about, you know, the early urgence of market efficiency, which (went into the faculty lounge at Stanford. He was — took agriculturally prices, and he showed them checks of — of prices, and he said, “These were chats of commodity prices.” And he wanted to see if they could identify bubbles in the prices. And every — to a man, they all — there were no women. To a man they all could.
The problem was what he was showing them was cumulative random numbers because that was just generated stuff. So the — the message there is people see bubbles where there are not.
RITHOLTZ: So here’s a — here’s a really broad question. Given the societal angst of people attacking the value of a business education, what is your belief in the value of this education, your Booth, and how should we communicate this better to society?
BOOTH: Well, I think it’s — it’s incredibly valuable to society because if we are going to make lives better for people, part of the answer has to come from better and safer financial products that is — that’s the reality and that’s been the history. I mean, it’s like I say I look back on my career, and working with Gene and, you know, we’ve been part of a — a movement towards lower fees and better controls, so I find it irritating when somebody says really the only advance the last 50 years has been the ATM, you know …
… it’s a …
RITHOLTZ: That was my voters quip.
BOOTH: Yeah. Like — we — based on all this work, live — we’ve improve lives and — and other people was sharing the ideas. We’re not the only one. But I mean, I — I don’t think it — it’s much better than that. And so I — I would hate to have people not get into business or particularly financial services. You can have a good career in financial services at the end of it. You can look back on it and take pride in what you’ve accomplished. It’s as simple as that.
RITHOLTZ: So — so that leads to the next question, what keeps both of you working? Neither you have to work. Why do both of you still get up and go to the office each day?
FAMA: It’s fun.
RITHOLTZ: It’s fun.
BOOTH: It’s important.
BOOTH: I mean, it’s exciting to see retired people living better as result of these ideas or better able to send their kids to college or whatever. And these are — these are not, you know, ideas that have no importance. I mean, these are — you know, that’s — you can get behind that kind of idea.
FAMA: You get a lot of satisfaction out of coming up with stuff people haven’t seen before or haven’t recognized.
RITHOLTZ: And we have time for one last question, and I’m going to go with something about what do you think the future of Chicago Booth looks like? What is next in store for the school? And this is for both of you.
FAMA: Well, I can tell you that the — so I’ve been on the faculty since 1963, a student since 1960. In the 60’s, basically there was a pretty good economics group. There was a developing finance group, and that was it. I mean, the rest of the school is junk.
FAMA: Well, but — but — that was not unique to us. So I remember when I was recruiting as a student in college not from here, the people recruiting said, “Why do you want to go to a business school? They don’t teach you anything. We don’t pay anything for — for what they — for what they do.” And that was true at that time, I think.
And what’s happened through time is not just finance but every other area has been academically made more — become more successful, so marketing, accounting. Statistics was always pretty good, but it was never part of — of business schools. So now we have really the front rank faculty in every single discipline. The school is so high — high-level competitive on the faculty side and the research side, but there’s no relation to what it was 50 years ago. It’s a totally different professional place.
On the student side, I think there was a challenge and I’ve been complaining about it for a long time. Students don’t work as hard as they did …
… in the old days. So …
RITHOLTZ: I’ve heard this is a very, very difficult school to work your way through.
FAMA: Well, but the reality is we — we keep track of hours worked for — per class, out of the class. When I started teaching, everybody was around 15 per class. That number has dropped dramatically through time.
RITHOLTZ: I — I bet this room would disagree with that.
FAMA: No, no, no, no, we have the statistics, it’s not …
… it’s not a — it’s not a guess.
RITHOLTZ: And — and, David, what do you see as the next decade holding for the Booth School?
BOOTH: Well, I’m — I’m not really in a position there. I mean, I just gave some money, I figured …
… figured that stuff out of my — had to figure that out as well. I mean, I — I would be a — a real hero. But no, I — I’m just — I’m not — I don’t know wherever it’s going to go, but wherever it goes is going to be important.
RITHOLTZ: And — and that’s the perfect spot to end. Ladies and gentlemen, please say thank you to Professor Gene Fama and David Booth.
BOOTH: Thank you.
(AUDIO CLIP ENDS)
RITHOLTZ: That’s my conversation with David Booth and Gene Fama. If you enjoyed that, well, go to Apple iTunes. Look up an inch or down an inch, and you could see any of the nearly 300 conversations we’ve had over the past five years.
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I would be remiss if I did not thank the crack staff that helps us put these conversations together this week. And this week was an unusual expedition. We all had to slip out to Chicago. The folks at the University of Chicago were great. They did a really great job in setting things up so that we could both videotape and audio record.
This Michael Boyle is my Producer, and he was on-hand there, along with a few other folks from Bloomberg that really made everything go very smoothly. Charlie Vollmer is my Audio Engineer who helped cut this monstrosity together. Atika Valbrun is our Project Manager. Michael Batnick is my Head of Research.
I’m Barry Ritholtz. You’ve been listening to Masters in Business on Bloomberg