Apr 21, 2015
Q&A

EFF/KRF: Our strategies for choosing papers are similar. Sometimes we don’t have a choice. If we agree to referee a paper or discuss it at a conference, we are certain to read it, and we read most of the papers our colleagues write.

 
Dec 2, 2014
Q&A

EFF/KRF: There is some confusion about the interpretation of the evidence in Fama and French (2014, “A Five-Factor Model of Expected Returns”) that HML is redundant for explaining average U.S. stock returns for 1963-2013.

 
Jan 30, 2012
Q&A
What is the best way to describe the distribution of stock returns—a normal distribution, lognormal, or something else? What should investors do with this information? 
 
Jan 23, 2012
Q&A
In addressing a previous question ("Has the Equity Premium Puzzle Gone Away?"), you suggested that it requires 35 years or more to be reasonably confident of achieving a positive equity premium. Is the time frame similar for the size and value premiums?
 
Jan 17, 2012
Q&A
Baker, Bradley and Wurgler (FAJ 2011) find that low-volatility stocks in the US outperform high-volatility stocks and attribute this apparent anomaly to investor behavioral biases as well as limits to arbitrage. What do you make of their argument?
 
Jan 9, 2012
Q&A
We often hear the claim that some markets are less efficient than others—small company stocks, emerging markets, foreign exchange, and so on. Is there any evidence to support this assertion?
 
Jun 27, 2011
Q&A
Data from Ken French's website shows that sorting stocks on E/P or CF/P data produces a bigger spread than BtM over the last 55 years. Wouldn't it make sense to use these other factors in addition to BtM to distinguish value from growth stocks?
 
Jun 20, 2011
Q&A
What is the merit, if any, in using a country weighting scheme based on Gross Domestic Product (GDP) rather than market capitalization?
 
Jun 13, 2011
Q&A
Are expected returns for "socially responsible" strategies lower compared to a conventional approach?
 
Jun 6, 2011
Q&A
What is the relation, if any, between the practice of "front running" trades and the efficient market hypothesis?
 
May 23, 2011
Q&A
Is there a liquidity risk factor in stock returns that helps explain differences in average returns?
 
May 9, 2011
Q&A
If US Treasury bonds are not risk-free due to inflation risk, does it make sense to diversify a portfolio of government bonds with obligations of other countries?
 
Apr 25, 2011
Q&A
Do high-beta stocks have high expected returns? Do stocks with historically above-average betas exhibit above-average realized returns?
 
Apr 11, 2011
Q&A
Can you address the pros and cons of short-term bond funds versus laddered bond strategies holding individual issues?
 
Apr 4, 2011
Q&A
Financial theory suggests that a global value-weight market portfolio is the logical default position for an equity investor seeking the optimal allocation scheme across countries. 

What are the implications for this approach if we take structural factors into account that encourage a home bias? Australia, for example, offers tax incentives applicable only to local investors, so their citizens earn higher returns than foreign investors do holding the same stocks. Brazil accomplishes the same thing by imposing additional taxes on foreign investors. 

Would it make sense for foreigners to weight each country using a market cap adjusted to reflect only non-local holdings?
 
Nov 1, 2010
Q&A
There seems to be some confusion about your opinion on the role of commodities in a portfolio, based on a conference presentation for financial advisors in 2004. Have your views changed since then?
 
Oct 18, 2010
Q&A
If you are familiar with a recent survey of mutual fund performance by Fundquest (Jane Li, "When Active Management Shines vs. Passive," June 2010), your comments would be appreciated.
 
Sep 27, 2010
Q&A
Many experts characterize the current environment as a "stock picker's market." Is there any evidence that stock selection is more successful under certain market conditions?
 
Sep 20, 2010
Q&A
How can investors achieve exposure to commodities by investing in stocks?
 
Sep 13, 2010
Q&A
The "Flash Crash" on May 6, 2010, is generally attributed to the growth of automated or "high frequency" trading programs. How have they affected market volatility and security valuation and what, if anything, should investors do differently?
 
Aug 4, 2010
Q&A
Does an equity strategy focusing on stocks with above-average dividend yield offer an appealing risk/reward tradeoff? Have dividend-paying stocks outperformed non-dividend payers in the U.S.?
 
Jul 28, 2010
Q&A
Does the deteriorating financial condition of the U.S. government diminish the appeal of U.S. Treasury securities as a risk-free asset? Should investors consider adding government securities from other countries to diversify?
 
Jul 21, 2010
Q&A
What model for executive compensation at public companies would you like to see? Should shareholders vote on these matters?
 
Jul 14, 2010
Q&A
To what extent do the limits of arbitrage (Schleifer and Vishny, 1997) discredit the idea of market efficiency?
 
Jul 7, 2010
Q&A
Should investors expect higher returns from private equity investments as compensation for the lack of liquidity? Does private equity offer a useful diversification benefit in a balanced portfolio?
 
Jun 30, 2010
Q&A
Can put or call options be used to achieve a more predictable risk-return tradeoff? For example, should I purchase put options to minimize equity portfolio losses?
 
Apr 28, 2010
Q&A
Some economists argue that prohibiting insider trading does more harm than good by reducing the flow of useful information. Do you agree?
 
Apr 21, 2010
Q&A
Is semi-variance a more useful measure of downside risk than standard deviation? My clients aren't worried about market surges, they're worried about market crashes.
 
Apr 14, 2010
Q&A
Based on spot price data from January 1970 through February 2010, the average return on gold bullion was almost exactly the same as the S&P 500 at 88 basis points per month. Volatility was significantly greater for gold, but since gold prices tended to zig when equity prices zagged over this period, a portfolio composed of 80% stocks and 20% gold (rebalanced annually) had lower volatility than either of its component parts. Doesn't portfolio theory suggest that gold can make a useful contribution?
 
Feb 23, 2010
Q&A
Why do shares of widely held bankrupt firms such as GM often trade well above zero even though the interests of common stock holders appear almost certain to be eliminated in reorganization? Is this behavior an example of mispricing?
 
Feb 10, 2010
Q&A
In their book Valuing Wall Street published in early 2000, Andrew Smithers and Stephen Wright claim that the q ratio popularized by Nobel laureate James Tobin reliably identifies periods of extreme overvaluation and undervaluation in stock prices. Can investors use this indicator to implement a successful market timing strategy?

EFF/KRF: This proposition has been tested in several papers, and the answer is no. The market-to-book ratio for the market (a proxy for q) shows some ability to predict stock returns during the 1930s, but not thereafter.

 
Feb 3, 2010
Q&A
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?
 
Jan 22, 2010
Q&A
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.

 
Dec 14, 2009
Q&A
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
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 17, 2009
Q&A
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
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
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)

 

 
Sep 17, 2009
Q&A
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.

 
Sep 15, 2009
Q&A
How useful was Monte Carlo-type analysis in preparing for the recent downturn in the economy and stock market? Is there an alternative approach that investors should consider in an effort to address the uncertainty of future returns?

EFF: Monte Carlo analysis is overkill here. All one really needs is good historical perspective on the volatility of volatility. Our white paper, "How Unusual Was the Stock Market of 2008?", is a good start. 

KRF: Monte Carlo analysis is often worse than overkill because it gives many users a false sense of precision. If used right, it can provide some perspective about the payoff on a long-term investment. Investors who do Monte Carlo simulations, however, often assume returns are drawn from a normal distribution with a constant volatility. In fact, a normal distribution produces far fewer extreme returns than we see in the market. Moreover, it is easy to forget that the inputs for the analysis - the estimated expected returns, variances, and covariances - are almost certainly grossly imprecise.

 
Aug 31, 2009
Q&A
Richard Thaler observes "Efficient market guys have to be willing to claim that the NASDAQ is efficiently priced at 5,000 and at 1,400. That's a tough sell." Comments?

EFF: Stock prices depend on two factors: expected profitability and the expected returns investors require to hold stocks. Both can vary dramatically through time. Thus, widely different levels of the market at different times are quite consistent with market efficiency. Indeed, they are required for market efficiency. This might well be a tough sell, but it's Finance 101. 

KRF: Dick is referring to the behavior of stock prices during the tech boom and bust of 1995-2001. Gene is certainly right that market efficiency requires prices to adjust to new information about future cashflows and discount rates. 

(Read the full entry)

 
Aug 27, 2009
Q&A
We often hear that the investment world must adjust to a "new normal", reflecting a permanent shift to greater market volatility worldwide. How should investors revise their portfolios in response to these developments?

EFF: There has always been lots of variation through time in market volatility, and volatility tends to be mean-reverting. (See our white paper, "How Unusual Was the Stock Market of 2008?") If investors can't tolerate periods of high volatility in stocks, this should affect their decisions about stocks, whether or not volatility is currently high. 

KRF: It is certainly true that stock market volatility is higher now than it was two or three years ago. At the end of 2006, the VIX, a measure of the annual stock market volatility implied by S&P 500 option prices, was below 12%. 

(Read the full entry)

 
Aug 25, 2009
Q&A
Long-term government bonds outperformed the S&P 500 Index by 0.12% per year for the forty-year period ending March 2009. Does a negative risk premium for stocks vs. bonds over such a long period challenge conventional thinking about risk and return?

EFF/KRF: It is important to distinguish between the expected equity premium, which should be positive, and the realized premium, which is the expected premium plus the unexpected premium. Investing in stocks is risky because we do not know what the unexpected premium will be. 

(Read the full entry)

 
Aug 20, 2009
Q&A
U.S. budget deficits keep expanding and some of our largest trading partners have begun to question the dollar's role as the world's reserve currency. Both trends suggest a dim future for the purchasing power of the U.S. dollar. Does a diversified equity / fixed income strategy represent the soundest way to address this challenge?

EFF/KRF: Recent Government actions, both fiscal and monetary have created lots of uncertainty about future inflation. Stocks may compensate for inflation in the long-term, but in the short-term they are not very good. And there is so much other uncertainty in stock returns, stocks are not in any case a good specific inflation hedge. TIPS and short-term bonds are good inflation hedges. If you are concerned about inflation risk, you may want to allocate more to them, probably in the tax-sheltered components of client portfolios.

(Read the full entry)

 
Aug 17, 2009
Q&A
Stock market analysts often claim that hedge funds represent a significant percentage of trading volume in securities markets. What effect, if any, do hedge funds have on stock and bond prices?

EFF/KRF: Good question, but we know of no evidence on the matter. For example, hedge funds might make markets more efficient or they might reduce the accuracy of financial prices.

 
Aug 6, 2009
Q&A
A buy-and-hold for stocks appears to work well for long periods (such as 1975 - 1999) but then does poorly for extended periods as well, such as the most recent ten years. Isn't it clear that there are "seasons" for stocks that make the climate favorable or unfavorable for investors?

EFF: We always emphasize that ten years is not a long period for stock returns, and ten-year periods with negative market premiums are common. A long period is basically an investment lifetime (35+ years).

KRF: After the fact it is easy to identify periods in which stocks did well and periods in which they did poorly. But if you want to use these "seasons" to build an investment strategy, you have to identify them before they occur - and that is not so easy. The seasons analogy creates the false impression that, like spring, summer, fall, and winter, the favorable and unfavorable periods follow a regular and predictable cycle. Droughts in Australia might be a better analogy. We don't know when the next one will occur and we don't know how long it will last when it does.

 
Aug 4, 2009
Q&A
Index funds buy stocks "blind" without regard to company fundamentals. Do their activities contribute to mispricing of securities?

EFF: Index funds typically buy cap-weighted portfolios so they do not contribute to mispricing. 

KRF: We analyze a general version of this question in "Disagreement, Tastes, and Asset Pricing" (Journal of Financial Economics, 2007). Suppose index fund investors hold a passive market portfolio. Then from a pricing perspective they are sitting on the sideline. They are not overweighting or underweighting any securities, so they do not affect (relative) prices. As a result, it is hard to argue that they contribute to mispricing.

(Read the full entry)

 
Jul 29, 2009
Q&A
John Cochrane* has suggested that the historical premiums for small cap and value stocks reflect "narrowly held risks" and that these premiums are likely to shrink in the future "until the markets have reached equilibrium, in which every investor has bought as much risk as he likes." Do you agree, and, if so, what are the implications for investors considering a small cap or value tilt in their portfolios? 

*"Portfolio Advice for a Multifactor World", Economic Perspectives, Federal ResereveReserve Bank of Chicago, 1999

EFF/KRF: Cochrane offers this notion of narrowly held risks as one of several explanations for the size and value premiums. The premise is that until the last couple of decades, individual investors had limited access to diversified portfolios of small stocks and value stocks. As a result, the prices of small and value stocks were lower than they would be if all investors had easy access, and their expected returns were higher. The introduction and growth of mutual funds that invest in small-cap and value stocks would then reduce the expected returns on these securities.

(Read the full entry)

 
Jul 27, 2009
Q&A
Firms often pay a substantial premium to the market price when making acquisitions. Does their willingness to pay a premium suggest the shares of target firms were mispriced?

EFF: The empirical evidence says that all the gains from mergers are eaten up in the premiums paid to acquire firms. On average, the acquiring firm gets nothing. This doesn't necessarily imply that the shares of the acquired firm were mispriced since there can be synergies (real business gains) from mergers. 

KRF: Takeover premiums do not imply that the target firms were mispriced. Since we do not expect the market to accurately forecast every acquisition that will create value, we should not be surprised that prices rise when tender offers and mergers are announced.

 
Apr 29, 2009
Q&A
Has the equity premium puzzle gone away?

EFF: There never was one. The "puzzle" comes out of a simplified economic model that says the average spread of the equity market return over the t-bill return has been too high, given the risk of equities. It is easy to show that this argument is silly. Thus, the returns from equity investing are quite risky. As a result, if the high average stock return of the past is the true long-term expected return, the high volatility of stock returns nevertheless means that getting a positive equity premium (of any size) is highly likely only for holding periods of 35 years (an investment lifetime) or more. Given this result, the historical equity premium does not seem too high.

(Read the full entry)

 
Apr 29, 2009
Q&A
George Soros claims (in his op-ed in the Wall Street Journal) that the Efficient Market Hypothesis is invalid, because prices in financial markets "always provide a biased view of the future, and that distortions of prices in financial markets may affect the underlying reality." Thoughts?

EFF: All the evidence I know says that market predictions are unbiased. It's understandable, however, that hedge fund managers are immune to this evidence since it's a threat to their existence.

(Read the full entry)

 
Apr 29, 2009
Q&A
I read an article recently profiling five signs that the recession is ending. What signs might you look at to indicate when the recession is ending?

EFF/KRF: We are not experts, but know enough about the academic research to be skeptical of the signals suggested by casual observers. The academics who study this find that the best leading indicators are not very powerful. It is hard to say when the recession will end until it has.

From an investment perspective, the market is always doing its best to incorporate information about future business conditions in current prices. As a result, other signals about the end of the recession are not likely to help you forecast the market.

 
Apr 29, 2009
Q&A
Is there such a thing as systemic risk in the financial system? Are some of our banking institutions truly "too big to fail?"

EFF: The term "systemic risk" is less than 20 years old. It has become a scare term that governments use to justify bailout actions detrimental to taxpayers.

"Too big to fail" is an especially perverse use of the systemic risk scare tactic. I think the policy rule should be "too big not to fail," that is, big losers among financial firms get shut down first, to signal other big financial firms that "too big to fail" bailouts are over, so the firms will behave more responsibly in the future.

(Read the full entry)

 
Apr 24, 2009
Q&A
I represent an endowment of about $30 million. In public equities we have most of our investments in market-wide mutual funds. What mix would you recommend between domestic, international and emerging markets for the public equity part of our portfolio?

EFF/KRF: There is no single right answer to this question. If there were one answer, it would have to be the market portfolio of domestic, international, and emerging stocks, since that is the only portfolio that can be held by everyone. Different tastes and circumstances, however, push investors away from the market portfolio and the optimal deviations vary across investors. For example, perhaps because of exchange rate uncertainty, people tend to overweight their domestic market. Similarly, some investors are happy to increase their expected return by tilting toward small stocks, while others prefer to reduce their risk by tilting toward large caps. It is important to diversify, but there is no single optimal mix.

 
Apr 24, 2009
Q&A
A recent change to a client's life needs would normally warrant a reduction in portfolio risk. In doing so immediately, he would forego future expected returns that he paid so dearly for in the last year. Could the severity of the recent downturn justify delaying a risk reduction?

EFF/KRF: No. Although the expected market return probably increased over the last year, this is the result of greater uncertainty about future returns and perhaps an increase in the overall level of risk aversion. If your client's circumstances warrant a reduction in risk, an increase in expected return that is caused by an increase in risk is not a good reason to stay in the market. 

 
Apr 24, 2009
Q&A
Recently, Professor Jeremy Siegel has challenged the method of calculating earnings for the S&P 500. He believes the calculation should be market weighted, as is the index. Standards and Poor's disagrees. In your view, who is correct?

EFF/KRF: In our research we calculate the E/P ratio for a portfolio just as S&P does, dividing the aggregate earnings of the firms in the portfolio by the total market equity. It is easy to see the logic if you imagine merging all of the firms into one giant conglomerate. The new firm's earnings and market equity are just the sum of the individual firms' earnings and market equity.

 
Apr 21, 2009
Q&A
Recently, I've heard some say "I got out of the market in May 2008 and I am sure glad I did." Given the obviously positive results of this decision, what is the best argument to convince people that buy and hold is better than timing the market?

EFF: Wins and losses from market timing bets are both just unpredictable chance outcomes, and good luck is, of course, better than bad luck. The problem with market timing is that you may be out of the market in periods of strong returns.

KRF: There is a large academic literature on whether market returns are predictable. The general conclusion is that it is impossible to predict the market return with any confidence... "A Comprehensive Look at the Empirical Performance of Equity Premium Prediction," by Amit Goyal and Ivo Welch (Review of Financial Studies, 2008), is a good summary of the evidence.

(Read the full entry)

 
Apr 21, 2009
Q&A
I have a client who is convinced that an inverted yield curve is a signal to get out of equities. What are your thoughts on this topic?

EFF/KRF: Inverted yield curves are often observed at the front end of recessions. But there's no evidence that they predict stock returns, which also tend to predict (decline in advance of) recessions. Your client's implicit premise is that bond market investors predict future economic activity better than stock market investors. The evidence says that both markets are moderately good at predicting future economic activity, and inverted yield curves are not reliable predictors of stock returns.

 
Apr 21, 2009
Q&A
What do you think of the mark to market issue?

EFF: It gives investors a good estimate of what a financial institution is worth. It has more flexibility than commonly realized, especially for illiquid assets, where best estimates of value can be used.

KRF: There is not enough empirical evidence to be sure who is right about this issue, but we can guess. Those against marking to market argue that the transaction prices for securities sold under duress do not reflect their true value. If you and I both own relatively illiquid assets and you choose to sell yours quickly at a fire sale price, mark to market accounting may force me to write down the value of my assets to your transaction price. Unless I also plan to sell my position quickly, this undervalues my position. The critical question, however, is whether your transaction price is more accurate than the model value I would use if I am not forced to mark to market. My guess—and this is only a guess—is that the observed transaction price is typically more accurate than the model. In other words, marking to market would improve the accuracy of my balance sheet.

 
Mar 18, 2009
Q&A
It would be very enlightening if you would comment on the Nassim Nicholas Taleb ("The Black Swan") attack on the use of Gaussian (normal bell curve) mathematics as the foundation of finance. As you may know, Taleb is a fan of Mandelbrot, whose mathematics account for fat tails. He argues that the bell curve doesn't reflect reality. He is also quite critical of academics who teach modern portfolio theory because it is based on the assumption that returns are normally distributed. Doesn't all this imply that academics should start doing reality-based research?

EFF: Half of my 1964 Ph.D. thesis is tests of market efficiency, and the other half is a detailed examination of the distribution of stock returns. Mandelbrot is right. The distribution is fat-tailed relative to the normal distribution. In other words, extreme returns occur much more often than would be expected if returns were normal.

(Read the full entry)

 
Mar 18, 2009
Q&A
What is the role of various derivatives instruments in maintaining an efficient market?

EFF: Theoretically, derivatives increase the range of bets people can make, and this should help to wipe out potential inefficiencies. Whether this actually happens is a difficult, perhaps impossible, empirical question. The "problem" is that markets seemed rather efficient before Black-Scholes (which initiated the derivatives industry), so there wasn't much for derivatives to do.

(Read the full entry)

 
Mar 18, 2009
Q&A
Is diversification working today, when we need it most?

EFF/KRF: When overall market volatility increases, idiosyncratic (security-specific) volatility also tends to increase. For example, market volatility is currently quite high, and the dispersion of the cross section of stock returns (which is idiosyncratic volatility) is also unusually high. Diversification has no effect on the volatility of the overall market, but it reduces the effect of idiosyncratic volatility on a portfolio's return. To put it differently, active investment is a riskier strategy when volatility is high because active portfolios are, almost by definition, poorly diversified.

In short, diversification is now more important than usual.

 
Mar 18, 2009
Q&A
Some have suggested this downturn is different because it is affecting the entire planet, not just a country or region, so previous downturns don't necessarily compare. Given the state of the world economy, is recovery beyond our grasp?

EFF/KRF: In the past, other countries have had recessions that the U.S. has not shared. But the U.S. is big, and every U.S. recession has been global. Thus, the global aspect of the current U.S. recession is characteristic of past U.S. recessions. Every past recession has ended. This one will too.

 
Mar 18, 2009
Q&A
Some think the exposures associated with credit derivatives are so extreme that the failure of one or two large financial institutions will ruin the nation. Could the use—or abuse—of credit default swap exposures be that dangerous?

EFF/KRF: As far as I can tell, the government bailout of AIG has gone largely to prop up its $2 trillion of credit default swaps. The fear of the Treasury and the Fed is that if AIG is forced to default on its credit default swaps, the "insurance" they provide to the value of bank assets will disappear, the value of the assets will fall, and lots of big banks will be insolvent. I agree that this is likely to be the eventual outcome, in other words, the Fed and the Treasury will eventually say "uncle" and let AIG and the bad banks fail. I think this is what they should have done from the beginning, and if they had we would be in better shape now. The stockholders and the bondholders of AIG and the failed banks will lose big time, but this will allow the banking sector as a whole to emerge in a stronger state. (See also my little paper "Bailouts and Stimulus Plans.")

 
Mar 11, 2009
Q&A
Some political commentators argue that Obama's economic policies are our path to ruin. Is capitalism really threatened by our recent political decisions?

EFF/KRF: Even in good times, economic systems are often changed dramatically by political decisions. (Think about South America over the last 30 years.) Capitalism is always under threat in the U.S., and the threat is higher when the legislative and executive branches are both in the control of liberal Democrats, who seem to be big admirers of the European system of high social welfare expenditures and "managed" (or better, mismanaged) capitalism. Unfortunately, the current political period may result in stagnation of the sort that other managed capitalist economies (Japan and most of Europe) have experienced. But we hope the pioneering free enterprise spirit of the U.S. can quickly reassert itself.

(Read the full entry)

 
Mar 11, 2009
Q&A
Newsweek recently proclaimed "we are all socialists now". How has government intervention changed expected stock returns?

EFF/KRF: Government intervention affects the market in two ways. First, it affects the level of expected future profitability, which has direct effects on stock prices. Second, government intervention and uncertainty about the government's future actions change the risk of expected future profits, which affects stock prices by raising or lowering the discount rates for expected future profits, and thus raising or lowering expected stock returns. Our view is that the rhetoric and sweeping initiatives of the new administration have lowered market expectations of future profitability, and the uncertainty about government policies has increased the risk of expected future profits. Both effects have contributed to the lower stock prices we have seen as the policies of the new administration have unfolded. If the market has it right (that is, if the market is efficient) all this is built into current stock prices, and expected returns are higher going forward. (See also the answers to Expected Return and Stimulus EffortsHedging Inflation with Bonds.)

 
Mar 11, 2009
Q&A
Is cash (that is, short-term riskless bonds) a safe investment if we think about future consumption and not about nominal dollars?

EFF/KRF: Short-term high grade bonds are a good hedge against inflation. If hedging inflation is your overriding goal, short-term high grade bonds are the route for you. (Gene has been saying this for about 40 years.) But don't expect much in the way of a real return. Short-term bonds maintain purchasing power, but they don't enhance it, since the real returns they produce are quite low (for example, less than %1 per year on T-bills). In other words, if you don't take much real risk, you can't expect much real return.

(Read the full entry)

 
Mar 11, 2009
Q&A
What can we say about expected return if we do not think the stimulus plan can have positive impact on the economy?

EFF/KRF: The recent sharp decline in prices suggests that the market does not think the actions of the government (including the stimulus plan) are, in aggregate, good for the economy. If you think the market has it right, then expected stock returns are high, for the reasons outlined above. If you are more pessimistic than the market about the effects of government actions, then (at least on this score) you think prices are too high, which means expected returns are low. Conversely, if you are more optimistic than the market about the effects of government actions, then you think prices are too low, which means expected returns are quite high. Keep in mind, however, that the empirical evidence says you are on thin ice when you decide your forecast of the future is better than the market's.

 
Feb 23, 2009
Q&A
It seems obvious now that firms facing extreme financial difficulty should be avoided.

EFF: This is a market efficiency question. If firms facing extreme financial difficulty are properly priced to take account of the risks they face, there is no reason to avoid them, unless you don't like the risks.

KRF: Whenever you think about a proposition like this, you should ask yourself, "What do you know that the market doesn't?" Does the market know the firms are facing extreme difficulty? If so, your best bet is that the price is right. This does not mean that the price is always right, or even that the market always incorporates all publicly available information. Sure the price of a distressed firm may be too high, but it is equally likely it is too low. To decide how the market has erred in a specific case, you have to know more than the market or you need a better model than the market. Although most investors seem to think they have the expertise to beat the market, an enormous amount of empirical evidence says this is a very high bar.

 
Feb 23, 2009
Q&A
What are the possible impacts from the ballooning Federal Reserve balance sheet? Will this necessarily lead to an inflationary environment? Is deflation a possibility? Are there any charts or figures to illustrate the effects?

EFF/KRF: Rather than provide a superficial answer to this question, Gene's colleague at Chicago Booth, John Cochrane, has a short but brilliant analysis of this and other issues related to recent government actions.

 
Feb 23, 2009
Q&A
Does passive management makes sense in all market conditions?

EFF/KRF: Active management is always a zero sum game, before fees, expenses, and trading costs, regardless of market conditions. If there are active winners, they win at the expense of active losers. And active management is always a negative sum game after costs. This is an algebraic condition, not a hypothesis. We call it equilibrium accounting.

Moreover, our research on individual mutual funds says that it's impossible to identify true winners on a reliable basis, even if one ignores the costs that active funds impose on investors. Funds that seem to be winners, based on past returns, were probably lucky rather than smart. After costs, that is in terms of returns to investors, there is no game to play; there is no evidence of managers with enough information to cover costs, other than on a purely chance basis. And there is no evidence that this depends on market conditions. If you are interested, see our paper Mutual Fund Performance.

In short, passive management and passive investing always make sense.

 
Jan 27, 2009
Q&A
Does it make sense to lend securities to speculators who are driving down prices and contributing to the volatility in the markets? Sure, the revenue from lending is nice, but if security lending pushes down stock prices, the net contribution maybe negative.

EFF: The evidence that short-sellers actually know something about market prices is weak. And even if they do, they only push prices more quickly to lower equilibrium levels, so they have little effect on the returns of long-term investors.

(Read the full entry)

 
Jan 27, 2009
Q&A
Should I put some portion of my portfolio in long-term US Treasury bonds as a hedge against deflation?

EFF/KRF: Perhaps, but you would have to put a high probability on deflation. Severe downturns in business activity do not always result in deflation. For example, during the depression of the 1930s, some countries experienced deflation and some experienced hyperinflation. There is lots of talk currently about deflation, but the huge commitments the Fed has made recently seem to be pushing toward higher inflation.

(Read the full entry)

 
Jan 27, 2009
Q&A
Are the Fama/French factors more correlated when markets go down? Are value portfolios riskier in bad times?

EFF/KRF: The two questions are related. Throughout the period from 1926 to now, small stocks have higher market βs (sensitivity to market returns) than big stocks. This means small stocks go up more in good market times and down more in bad market times. In terms of market sensitivity (β), small stocks are riskier than big stocks. Prior to 1963, value stocks have higher market βs than growth stocks, and during this period value stocks tend to move up or down more than the market. After 1963, value stocks have lower market βs than growth stocks, and after 1963 value stocks tend to move up or down less than the market. It is important to emphasize, however, that in the three-factor model of Fama and French, market β is not sufficient to describe the risks of common stocks. In the three-factor model, value stocks are always riskier than growth stocks because they are more exposed to a value-growth risk factor that is separate from market risk and is compensated differently in expected returns. In the three-factor model, portfolios of value and growth stocks have similar exposure to the market. This means that when there are big market moves, like those of the last few months, value and growth stocks (or at least diversified portfolios of value and growth stocks) move in much the same way. In other words, big market moves tend to dominate the returns on value and growth stocks alike.

 
Jan 19, 2009
Q&A
The Dow peaked around 14K in October 2007, one year later the Dow went to 7500. Was the market really in equilibrium last October given that it was on the verge of such a steep collapse? How can one address equilibrium given the daily volatility we are experiencing?

EFF: Every market determined price is an equilibrium price that should take account of all information available at the time the price is set. (This is the definition of market efficiency.) But things inevitably change, and equilibrium prices change along with them. All we can say about the recent market turmoil is that the volatility of information and its implications for forecasts of profitability must be quite high. 

KRF: Market efficiency does not imply prices cannot change. It does not even say they cannot change by a lot. The key question is whether we should have known the Dow would drop from 14,000 to 7500. Some who made fortunes by anticipating the drop seem to have convinced many observers that the outcome was obvious, but that is just history being written by the victor. Unlike the technology boom of 1999-2000, I don't recall lots of conversations in which people struggled to understand why the Dow was at 14,000.

 
Jan 19, 2009
Q&A
Have global correlations gone, effectively, to 1? Have cross-country and cross asset-class correlations behaved any differently this time than in previous downturns?

EFF/KRF: When market volatility goes up, cross-country and cross-asset-class correlations tend to go up. When market volatility is normal, events that are specific to countries, asset classes, or individual firms are a larger part of total volatility and correlations are low. When market volatility increases relative to other sources of volatility, the common variation becomes a larger part of total volatility and correlations go up. This effect has been particularly apparent recently because volatility has been extraordinarily high.

 
Jan 19, 2009
Q&A
The US economy is in a recession. Does it make sense to own stocks during a recession?

EFF/KRF: There is no evidence that market timing in response to economic events enhances expected returns. The market tends to lead economic activity. Stock prices tend to fall in advance of recessions and rise in advance of economic upturns. To time markets successfully, you have to come up with better forecasts of economic activity than those already built into stock prices. We don't know anyone who can do this.

Moreover, investors who try to time the market by selling after news of a recession is already in prices are probably reducing their expected returns. Although realized returns are too volatile to make strong statements, there is some evidence that expected stock returns are relatively high during recessions and low during expansions. One can avoid the higher risk of stocks during recessions, but apparently only by passing up higher expected returns.

 
Dec 31, 2008
Q&A
Some people have argued that the turmoil was caused by a lack of government regulation. What do you think? Do we need more regulation?

KRF: It is not obvious that financial regulations were weakened during the last few years. This claim seems to have been the product of a Presidential election in which both candidates were running against the incumbent. In fact, one could easily point to important new laws and regulations such as Sarbanes-Oxley to argue that market regulation increased. As more tangible evidence, the SEC's budget increased from $377 million in 2000 to $906 million in 2008. It is certainly true that different regulations could have reduced the magnitude of the current turmoil, but that is like saying a different portfolio allocation could have produced higher returns.

(Read the full entry)

 
Dec 31, 2008
Q&A

Is the market turmoil a sign that markets are not efficient? EFF/KRF: The market turmoil is caused by some combination of (i) quickly fluctuating changes in expected cashflows (future profitability), and (ii) variation in investor risk aversion that leads to variation in expected returns (the discount rates for expected cashflows). Both responses can be rational. In short, a change in volatility, by itself, says nothing about market efficiency. Of course, it is interesting to ask why the volatility of expected cashflows and expected returns increased so much, but that requires a much longer analysis.

 
Dec 19, 2008
Q&A
How useful is an approach based on historical data when the current situation appears to be unprecedented?

EFF/KRF: Any current situation is always somewhat unprecedented and somewhat old stuff. Large declines in stock prices occur several times during the last 80 years. The nearby plot of the volatility of daily market returns shows that the current high volatility also has precedents in 1987 and in the 1930s, and to a lesser extent in 2000-2002. Periods of business uncertainty (for example, the onset of a recession) are typically associated with stock price declines and increases in volatility.

 
Dec 19, 2008
Q&A
What would happen if many investors decided to sell their stocks and invest in Treasury bills instead?

EFF/KRF: Stock prices would go down and T-bill prices would go up - the usual response of prices to changes in demand. Of course, when T-bill prices go up the yield falls. Similarly, a reduction in prices caused by a large number of investors moving out of stocks pushes expected returns up.

 
Dec 19, 2008
Q&A
Stock market volatility is currently quite high. Does it make sense for investors to get out of the market until volatility settles down?

EFF: If the current high volatility makes you permanently averse to stock market volatility, and the inevitable variation in market volatility, you should get out. But you shouldn't have been in the stock market in the first place since fluctuations in volatility are the norm. If you eventually want to come back into the market, then you shouldn't leave. Bouncing in and out of the market is risky if your desired long-term asset allocation involves exposure to the market.

 
Dec 19, 2008
Q&A
Should I consider gold as a possible safe haven for some portion of my portfolio?

EFF/KRF: The volatility of gold prices (and of commodity prices in general) is much like that of stock returns. Gold is far from a safe haven.

 
Dec 11, 2008
Q&A
Do you think that the current investor deleveraging is playing a significant role in asset pricing? If so, has it been consistent with your views on asset pricing? Is this something we should be really concerned about?

EFF/KRF: The tools we develop in "Disagreement, Tastes, and Asset Pricing," published in the Journal of Financial Economics 83 (March 2007), 667-689, are helpful here. To keep the analysis simple, let's assume that (i) there is only one stock, (ii) I have $100,000 to invest, and (iii) for some reason, I want to own as much of the stock as possible. Compare two scenarios. In the first I cannot borrow so I just buy $100,000 of equity. In the second scenario, you are willing to lend me money to buy more stock. You are not crazy, however, so you limit my leverage to four to one. With $100,000 to invest I can borrow $400,000 and buy $500,000 of stock.

 
Dec 11, 2008
Q&A
How well has the three-factor model explained the recent behavior of stock returns?

 

EFF/KRF: For diversified portfolios, quite well. For example, the model's market, size, and value-growth factor automatically pick up changes in the volatility of the three factors. Keep in mind, however, that the model is not designed to predict the return on the market (or on SMB and HML), so it cannot call market turns.

 
Dec 11, 2008
Q&A
Do valuation measures such as price/earnings or price/dividend ratios help predict future returns? Are they telling us anything now?

EFF/KRF: Yes, but not with lots of confidence. The market return tends to be lower when aggregate ratios like E/P and D/P are low, and vice versa. The economic logic is based on the same discount rate effect we use to explain the higher expected return on value stocks. The empirical evidence leans toward a positive relation between aggregate fundamental to price ratios and future market returns, but there is lots of uncertainty about the forecast.

 
Dec 11, 2008
Q&A
What suggestions do you have for defined benefit plans as equities have lost 40% to 60% of value, year-to-date, with interest rates at historical lows, and liabilities that are growing.

EFF/KRF: Sorry, but there is no magic bullet here. Market events of the last few months underscore the risks of defined benefit plans to plan sponsors. As a result, we expect that DB plans will be even less popular among plan sponsors in the future.

 
Dec 11, 2008
Q&A
What is the validity of book value in today's environment, especially as it applies to financial firms?

EFF/KRF: There is always an issue about how to "properly" measure value. But all the work we have done says that at least for diversified portfolios, it doesn't much matter.

Alternative price ratios, like earnings/price and cashflow/price, work about as well as book/price, in terms of identifying value stocks and growth stocks. Every ratio has its problems because whatever fundamental one puts in the numerator has its own accounting issues. As a result, there are inevitable misclassifications of stocks, but they should wash out in diversified portfolios like ours.

We don't see any special problems with the book/price ratios of financial companies.

 
Q&A
Some researchers argue that a market timing strategy based on buy/sell signals generated by a 50- or 200-day moving average offers a more appealing combination of risk and return than a buy-and-hold approach. What is your view?

EFF/KRF: An ancient tale with no empirical support.

 
ABOUT FAMA AND FRENCH
Eugene F. Fama
The Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business
Kenneth R. French
The Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College
This information 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 Dimensional Fund Advisors and does not represent a recommendation of any particular security, strategy or investment product. Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.