Pioneer of Passive Investing, Eugene Fama Wins Nobel Prize

Clients of Bollin Wealth Management LLC who follow Dimensional Fund Advisors (DFA) mutual funds in the news may have recently seen some exciting news about a familiar face. Professor Eugene Fama, a finance professor at the University of Chicago’s Booth School of Business and Dimensional Fund Advisors board member, was one of three winners of the Nobel Prize in Economics; along with fellow professors Lars Peter Hansen of the University of Chicago and Robert J. Shiller of Yale University.

With a career spanning almost five decades, Professor Fama has spent much of his career demonstrating that stock markets are exceptionally efficient and that stock prices are extremely difficult to predict in the short run. One of the reasons, he postulates, that predicting stock prices is so difficult is that new information is very quickly incorporated into market prices making it very difficult to determine which stocks will have higher or lower earnings than expected. If one considers that Professor Fama’s work in the subject began in the 1960s when information wasn’t as readily as available as it is in today’s Internet age, then the task of determining which stocks are mispriced becomes even harder today!

The work of Professor Fama and fellow Nobel laureate Paul Samuelson have been inspiring people like John Bogle, the founder of the Vanguard group and arguably the most prominent name in indexing for four decades. Bogle took this inspiration and created the S&P 500 Index fund in the 1970s. Fama himself has been guiding the investment approach of Dimensional Fund Advisors, another proponent of passive investing, for over thirty years. David Booth, the founder of Dimensional Fund Advisors LP, was a student of Professor Fama in 1969.

But just because stock prices and movements are difficult to predict in the short run, that doesn’t mean that we can’t identify long-term success factors for investing in equities. The work of Professor Fama and his long-time research partner Professor Ken French of the Tuck school of business at Dartmouth College has found evidence that four factors, or dimensions, can lead to outperforming the broader-based market. These four factors, or dimensions (which inspired the name Dimensional Fund Advisors) include smaller size stocks outperforming larger stocks over time, value stocks outperforming growth stocks over time, stocks with pricing momentum, and high quality (highly profitable) stocks returning higher-than-average returns for investors.

Additionally, research conducted by Professor Fama during his career shows that approximately 97% of managers or actively-managed mutual funds demonstrate no skill to cover the higher expenses that these funds charge. Because of this research, advocates of index or passive-investing, like Professor Fama and John Bogle argue that it is a fruitless endeavor to try to beat the equity markets through active management.

Professor Fama’s research, along with the work of fellow contributors Paul Samuelson, Harry Markowitz and Professor Ken French have shed new light on factors for successful investing and revolutionized the investing industry. The evidence of their impact is overwhelming as investors have moved asset away from actively-managed mutual fund companies like American Funds and increasingly placed them with passively managed fund companies like Vanguard and Dimensional Fund Advisors. According to data obtained from Morningstar Inc., investors have pulled $284 billion from actively managed equity mutual funds while depositing $243 billion into stock index mutual funds since the end of 2008. Dimensional Fund Advisors now has more $300 billion in assets and ranks as the eighth-largest mutual fund firm in the United States.

Sources: Wall Street Journal, InvestmentNews, Dimensional Fund Advisors, Morningstar Inc.