The winning investment strategy according to Nobel Laureate, Eugene Fama

“An investor doesn’t have a prayer of picking a manager that can deliver true alpha.”

Eugene Fama is the American economist people lend their ears to, for this is the man who, after studying markets for more than 50 years, revolutionised our understanding of it. He is widely known as the ‘Father of Finance’ for his ground-breaking work on stock market behaviour. This groundwork that he laid as Efficient Market Hypothesis was highly influential in the ‘60s and ‘70s. If there is one takeaway from his years of research, it is that stock price movements are unpredictable and one is better off trying not to beat the market.

Fama is always seen scoffing at active managers – “I’d compare stock pickers to astrologers but I don’t want to bad mouth astrologers” – who, with their highly specific investments, try to achieve just that – a way to beat the market by picking winners. Fama has always believed that active managers are riding on an incredible amount of chance as “the research shows that it is impossible to pick people who can beat the market.”

What, then, is the winning formula?

Understanding the market

The Efficient Market Hypothesis says that the markets are efficient, in that, all relevant information is already priced into the market, making the attempt of beating it futile. Adding to this is the various dimensions of risk that create various dimensions of returns. According to Fama, in the process of picking stocks believed to be winners, people tend to not factor in this wide range of risks, a concern which should be the basis of investment decisions.

Indexed funds over actively managed funds

Fama’s work was seminal in changing market practice because Index funds picked up momentum and became the default investment option for people. The passively managed Index funds are a reflection of the market index, making them easy to understand, and a safer approach to investments. More importantly, it allows for investments in broad segments of the market so that even if one market crashes, you will still be standing upright. Fama likes to point out a certain piece of logic here – owning more bonds equals lesser stock-market risk. Active management on the other hand, due to its pickiness, will be more affected by changes in the stock-market.

Fama also points out that even with high-performing actively managed funds, the portfolio will look like index funds in the long run, indicating that active managers will eventually need to own most of the market. This can be a costly affair as operational costs for active management is very high and therefore, active managers, according to Fama, will have to be lucky to get their returns.

Explaining the exceptions

Fama likes to brush aside the successful trail left by stock pickers as luck. He says if one does manage to insulate a company from losses, then that is the result of pure luck as there’s no room for insulations in the market. “The good (picks) might be good or they might be lucky. The bad ones might be bad or they might be unlucky. We can't really tell the difference,” is his explanation.

There have been exceptions to Fama’s belief on the futility of active management. Warren Buffet’s Berkshire Hathaway Inc., has been consistently outperforming indexes, giving critics of Effective Market Hypothesis a concrete argument against Fama. On this matter, Fama points out that Buffet is someone who has the liberty to pick a company every couple of years, but for someone looking to build a portfolio, passive is the way to go.