Eugene Fama and David Booth on the Birth of Modern Finance

The 1970s were a pretty eventful time in markets. There was high inflation, the end of the gold standard, and a stock market crash. There was also a bunch of ideas coming out of the University of Chicago that would go on to be famous and highly influential for investors. Perhaps the most prominent is the Efficient Market Hypothesis, posited by Nobel Laureate Eugene Fama, which says that markets are right and it's useless for investors to try to outguess them. Fama later teamed up with David Booth, the founder of Dimensional Fund Advisors, and has been a longtime collaborator with the firm, which now has $777 billion under management. Today, they're releasing a documentary directed by Errol Morris and called "Tune Out the Noise," which chronicles this important time. We speak to both of these investment legends about the development of their theories, how they put them into practice, subsequent criticism, and what comes next. Read more:Wall Street Math Wizards Are Decoding Private-Market ReturnsUpstarts Challenge a Foundation of Modern InvestingCliff Asness Says Markets Are Less Efficient — And Social Media May Be to Blame Odd Lots is coming to Washington, DC! Get your tickets for our Jones Act debate here. See omnystudio.com/listener for privacy information.

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Speaker 00

  Finance is increasingly being built on digital rails. But as the adoption of virtual assets, tokenization and stable coins grows, can regulation not only keep pace but help accelerate it? Find out more later in the podcast.

• 0:16Speaker 01

  This is the Bloomberg Tech Minute brought to you by ChatGPT. I'm Carol Muster. Getting hired at SpaceX requires exceptional ability and may include having Elon Musk review a candidate's resume. So writes Bloomberg Business Week's Lauren Grush. She reports that the company culture is defined by Musk and job candidates must understand that a commitment to SpaceX means adhering to this culture and exhibiting loyalty to Elon Musk. To get hired, candidates must demonstrate their achievements from past jobs and hands-on experience matters more to recruiters than advanced degrees, with the company looking for people with raw innate intelligence. A spokesperson for SpaceX didn't respond to a request for comment on its recruiting

• 0:58Speaker 01

  and hiring practices, but according to recruiters, advisors and those who've interviewed for jobs there, it's the space exploration dream that draws people to the company and Musk invokes that dream regularly to remind workers why they're there. Prospective hires are told that the job will require stamina, including in job ads that candidates "must be willing to work extended hours and weekends as needed." One major perk for all that hard work? Employees' access to equity, either the right to buy shares or payment in the form of restricted stock units that vest over time. That's the Bloomberg Tech Minute brought to you by ChatGPT. Get started at chatgpt.com.

• 1:41Speaker 01

  Bloomberg Audio Studios. Podcasts, radio, news.

• 1:57Tracy Alloway?

  Hello and welcome to another episode of the All Thoughts Podcast. I'm Tracy Alloway.

• 2:02Joe Weisenthal?

  And I'm Joe Weisenthal.

• 2:03Tracy Alloway?

  Joe, what's your favorite financial movie? I don't think I've ever asked you that question.

• 2:08Joe Weisenthal?

  Really? I mean, Trading Places.

• 2:10Tracy Alloway?

  Oh, that's funny. That's mine, too.

• 2:13Joe Weisenthal?

  Yeah.

• 2:13Tracy Alloway?

  And not only because it's funny, but because it led to a real life development, which I don't think a lot of people know, but the CFTC set up something called the Eddie Murphy Rule.

• 2:24Joe Weisenthal?

  I didn't know.

• 2:24Tracy Alloway?

  Because of Trading Places.

• 2:25Joe Weisenthal?

  I have no idea where you're going with this.

• 2:27Tracy Alloway?

  And I think there has been an enforcement action. Well, what I was going to say is I think there is actually a lack of really good financial movies.

• 2:34Joe Weisenthal?

  Ah, okay, here you go.

• 2:35Tracy Alloway?

  Trading places aside.

• 2:38Joe Weisenthal?

  Yes, I would agree with that.

• 2:39Tracy Alloway?

  Yeah, I know we have The Big Short and Margin Call was a very realistic description of what it's like to work at a bank. But I think we need more in our lives. And I think we also need financial movies that sort of delve into some of the theories of financial markets. And I get why we don't. Those are really difficult to illustrate in a visual way, but I still want them.

• 3:02Joe Weisenthal?

  Me, too.

• 3:03Tracy Alloway?

  All right.

• 3:05Joe Weisenthal?

  Keep going, Tracy.

• 3:05Tracy Alloway?

  Okay, well, the good news is I just watched one that fits into that category. So there's a new documentary out called Tune Out the Noise, and it's all about the birth of modern finance. And it features an absolutely all-star cast of financial luminaries. So, you know, there are people like Martin Miller, Myron Scholes, Ken French, Markowitz, like the list goes on and on and on. And we're going to talk to two of them today.

• 3:36Joe Weisenthal?

  I'm really excited because I'm finally going to have a chance to ask, is it all priced in? Because this is my core belief about markets that is like, no, it's all priced in. And yet there appears to be a financial industry that must on some level be premised on the idea that it's not priced in, but I always assume that it's all priced in. And so maybe we'll finally get an answer to this question.

• 3:59Tracy Alloway?

  I suspect the way you feel about the term premium is the way I feel about the efficient markets hypothesis, but let's get into it. We are speaking with David Booth, the founder and chairman of Dimensional Fund Advisors, and Professor Eugene Fama, who is of course a Nobel laureate. He is also a director at Dimensional, has had a long running intellectual partnership with the firm. He's also sometimes called the father of modern finance. I could keep going on with the honorifics here, but you get the idea, I think. So David and Jean, welcome to the show.

• 4:31Speaker 04

  Thank you.

• 4:31Speaker 05

  Well, thanks for having us and looking forward to it.

• 4:35Tracy Alloway?

  I guess I'll start with the obvious question, but why a documentary movie about modern finance? It is, as I mentioned earlier, not exactly an easy story to tell visually.

• 4:47Speaker 05

  Well, it didn't start out to be a documentary. What happened was we started working with Errol Morris. You know, he won the Academy Award for his film Fog of War, well-known documentarian. And I was talking to him about how we could use some of his expertise for our firm. And he got really into it. He had no, not much background in finance and just got so fired up. He wanted to make it his film rather than our film, which I found to be very exciting.

• 5:16Joe Weisenthal?

  That's cool. We've done an episode with Dimensional's co-CEO Jared O'Reilly. Why don't you talk to us a little bit about the partnership of the two of you? For people who are not familiar, for people who are going to be watching the film for the first time, the two of you have been working together for literally decades and really two of the biggest names truly in the history of finance. What is the sort of short version of the sort of intellectual partnership and how this firm Dimensional came about?

• 5:48Speaker 04

  Well, David was my research assistant 55 years ago, David. Anyway, he was working with me for several years at the University of Chicago. And finally he came to me and said, I see what you do and I don't want to do it.

• 6:06Speaker 04

  He said he wanted to go off and work in the financial industries. So I called Mac McQuown and got David a job that way with Wells Fargo, I guess it was at the time, David, right?

• 6:17Speaker 05

  Right. In 1971.

• 6:20Speaker 04

  Then eventually he went off on his own, founded Dimensional and came back to me and asked me if I wanted to be somehow involved. We've been going at it ever since.

• 6:29Tracy Alloway?

  Oh, yeah, this was in the movie. So I think Wells Fargo basically just decided to share some of its data and analysis with Vanguard, like at the very beginning of Jack Bogle's career. And everyone was sort of scratching their heads about why that happened. But do we have any sense of why that happened? Was there just a spirit of research or academic camaraderie that made private organizations share things with each other?

• 6:54Speaker 05

  Well, one of the things I've always admired about Gene is his research, which we use extensively, he's always insisted that his research be in the public domain. We're not in the business of creating black boxes that nobody understands. So it's so critically important to have an open air philosophy about sharing research. And so Wells, you know, got off to a slow start in some ways, but it was a fundamental question. You can even track the performance of an index. And so Wells had done a lot of simulations and stuff. And when the group I was working on at Wells got shut down, Mac just volunteered

• 7:37Speaker 05

  to Bogle to share all of his data with him.

• 7:41Joe Weisenthal?

  Hmm. Gene, I'm curious, from your perspective, how did this interest you as a intellectual field of study? And we'll get into some of the specific, you know, sort of groundbreaking contributions to what many people now consider absolute truths to how the market worked. But this, some of your ideas, like why, what attracted you to the study of markets and some of your early research?

• 8:07Speaker 04

  Well, I started on it in college, actually. I worked for a professor at Tufts that had a stock market forecasting service. And my job was to come up with new ways to beat the market.

• 8:19Speaker 05

  How'd that go?

• 8:20Speaker 04

  It didn't go very well, but in the following sense, he was a very good statistician, so he always kept a holdout sample. And my ideas always worked in sample, but they never worked out of sample. So that was my first lesson on what you can expect by trying to beat the market. And after that, I went off to Chicago, took my data with me from Tufts and eventually wrote my thesis using that data, which was kind of the first or maybe the one of the bigger trumpeting of fishing markets. The term wasn't even called that at the time, but eventually that term came around as well.

• 9:00Speaker 05

  One of the things that's interesting about that, observe, he did a study based on data collected by hand. And that was kind of the state of the world when I went to Chicago to do a research project. Frequently you had to hand collect the data. You know, these new kids today wouldn't be aghast if they knew how we did things in the old days.

• 9:22Tracy Alloway?

  Well, I remember in the old days of Bloomberg, we often inputted a lot of financial. If you're working in the global data department, you certainly inputted a lot of things by hand as well. This leads to a question I wanted to ask you. So a big chunk of the documentaries about all these different people who spent time at the University of Chicago. What was in the water at the university that attracted all these names that went on to do big things in finance?

• 9:49Speaker 04

  Well, Merton Miller was an important person. He was deeply interested in this stuff. And Harry Roberts was another important person who had written on something resembling what would be now called the fishing markets way back in the 50s. So he was very much interested in it. And they were kind of the two shining lights in this area. And plus then there were a lot of PhD students, including me, who needed thesis topics. So having faculty interested in the topic was a good way of having research done by students in that topic because that was the way to graduate. And at the time, I had two kids with another one on the way. So I was very, very keen on getting out quickly.

• 10:34Speaker 05

  Well, I would also add, you know, Jim Laurie, I mean, Jim and Larry Fisher, they persuaded Merrill Lynch to fund a study to collect a survivorship bias free database, which enabled all these new young hotshots to do their research. And until that point, the data had never been collected correctly. And so you couldn't really do the research. So.

• 11:01Speaker 04

  Well, when Larry started out to, Larry Fisher started out to collect that data and put it together, a computer didn't exist that could handle it. But he said, well, it's going to come along. By the time we finish this, there'll be a computer to handle it. And he turned out to be right.

• 11:17Joe Weisenthal?

  Well, actually, this is exactly what I wanted to ask. And I think it sort of speaks to like a big theoretical question. Let's say part of good investing is having good data. Like, if you have to collect the data by hand, you're already going to probably knock out 99.9% of the people who have interest, because I wouldn't do it, because my wrists get really tired really fast. And my handwriting is garbage. So I wouldn't even be able to read what I had written in the graph paper, etc. A lot of things that we take for granted about investing today, including measuring the performance of an index, are things that literally take a few keystrokes or less on a Bloomberg terminal today. And I'm curious,

• 12:01Joe Weisenthal?

  like, when you think about, like, generating superior returns over time, how much of an edge was that to just be willing to do the hard work of collecting data?

• 12:14Speaker 05

  Look, all these tests of market efficiency, which started in the 60s, you know, and have keep showing the same result ever since, even though with increasing levels of sophistication of researchers and people having access to more and more, more data, better data, faster data. All of that, it still shows the same outcome of it doesn't look like trying to outguess the market is a winning game.

• 12:41Tracy Alloway?

  Hmm. So, since we're on the subject of the efficient markets hypothesis, one of your former students who also went on to great fame, Cliff Asness, he published his own paper called "The Less Efficient Markets Hypothesis," and it argues that markets are less efficient than they once were, in part because social media has basically turned us all into trend-following idiots, I guess. And this is something that I've occasionally wondered, if the efficient markets hypothesis is reliant on people making the right decisions with the information that they have or the data they have, what happens if we all get

• 13:18Tracy Alloway?

  collectively more stupid? And I guess a different way of asking this is, has your view of the efficient markets hypothesis changed at all over time?

• 13:30Speaker 04

  Uh, no, it hasn't really changed. It's adaptive in the sense that I never said that the market was efficient for everybody. There are, for example, there's lots of evidence, for example, that company insiders have information that isn't already in prices. So, as far as they're concerned, the stock of their company is not priced efficiently. That's one instance of it. But as far as professional managers are concerned, there is evidence that if you give them back all their fees and expenses, there are some who do have enough information to beat the market. But if you don't take out the fees and expenses, then the active

• 14:10Speaker 04

  managers look terrible relative to the passive managers. So, that's the kind of data and results that makes market efficiency look pretty good. But it's not, it's just a hypothesis. It's not a literal truth. It's just an approximation to the world. But it worked really well for almost everybody.

• 14:47Speaker 00

  What's next for virtual assets? I'm Jacob Grease, host of Economy Scale, a series exploring growth in key global sectors. And in this episode, we're diving into the digital forces shaping finance. Sean McHugh from Dubai-based Virtual Assets Regulatory Authority has this to say.

• 15:02Speaker 06

  We're seeing a lot of institutional players come in, digital asset dedicated hedge funds, high-frequency traders and that sort of thing, and folks who service institutional clients.

• 15:11Speaker 00

  As more capital enters the market, adaptive regulation is likely to become increasingly key. Reece Merrick of Ripple says.

• 15:19Speaker 07

  A lot of regulators globally would like to keep the industry at arm's length. That's the opposite here. I think also what you'll find is that regulation and frameworks can come out, but some of them are maybe a slight iteration on some 80-year-old policy and not actually in line with what the technology can do and offer. And again, that's very different in Dubai.

• 15:38Speaker 00

  Listen to the full episode wherever you get your podcasts. This series is brought to you by Bloomberg Media Studios and the Dubai Department of Economy and Tourism.

• 15:48Speaker 01

  This is the Bloomberg Tech Minute, brought to you by ChatGPT. I'm Carol Muster. Getting hired at SpaceX requires exceptional ability and may include having Elon Musk review a candidate's resume. So writes Bloomberg Businessweek's Lauren Grush. She reports that the company culture is defined by Musk and job candidates must understand that a commitment to SpaceX means adhering to this culture and exhibiting loyalty to Elon Musk. To get hired, candidates must demonstrate their achievements from past jobs, and hands-on experience matters more to recruiters than advanced degrees, with the company looking for people with raw, innate intelligence. A spokesperson for SpaceX didn't respond to a request for comment on its recruiting

• 16:30Speaker 01

  and hiring practices, but according to recruiters, advisors and those who've interviewed for jobs there, it's the space exploration dream that draws people to the company, and Musk invokes that dream regularly to remind workers why they're there. Prospective hires are told that the job will require stamina, including in job ads. That candidates quote must be willing to work extended hours and weekends as needed. One major perk for all that hard work employees access to equity, either the right to buy shares or payment in the form of restricted stock units that vest over time. That's the Bloomberg Tech Minute brought to you by ChatGPT. Get started at ChatGPT.com.

• 17:11Joe Weisenthal?

  So this gets to like a question that I've asked before and I'm now thrilled to get to ask it to you, which is why does the financial industry exist if markets are efficient? Because there are a lot of people that collect very big paychecks from some notion that they can deliver better returns than someone else to their clients. If markets are efficient, at least to most people in the industry, why do we have this industry?

• 17:43Speaker 04

  Because there are people who think they can pick the managers that have special information. That's what keeps it going. That's what keeps the active managers going. It's individuals who make who don't think that passive investing is for them. And they invest, they go with the active people. So that markets are always about competition among different kinds of players. And then we see who comes out on top.

• 18:09Tracy Alloway?

  Gene, how serious are you when you say stuff like there's no such thing as a bubble? Or that bubbles are only identifiable after they burst, so it's pointless to talk about them.

• 18:19Speaker 04

  Deadly.

• 18:20Tracy Alloway?

  Very serious?

• 18:21Speaker 04

  Right.

• 18:21Tracy Alloway?

  Explain it more because Joe and I have lots of episodes where we talk about either past bubbles or overvaluations.

• 18:28Speaker 04

  Yeah, so with 2020 hindsight, it's always, you know, it's explain why prices went up and why, why they, why they went down. But in my view, what a bubble means is price has gone up and you can predict when it's going to go down and when that, when that, that whole phenomenon is going to, that whole price movement is going to go away. And that's what's proven really difficult to do. So lots of people use the word bubble very loosely. I I I cancel my subscription to The Economist because using the word to describe.

• 19:04Joe Weisenthal?

  Us journalists are terrible about overusing BOW. I will cop to that on behalf of the entire profession.

• 19:11Speaker 04

  Right. So I need to know what the definition is before I can respond to it. And in that case, that's much more difficult. Most people aren't willing to do that. There are economists that are willing to do it, and I can deal with that. There has to be some predictability about when it's going to end. And that's what proven to be really difficult to establish.

• 19:31Joe Weisenthal?

  Right. It seems fairly clear that you could sort of sense like we're in some sort of mania. And even knowing that fact and everyone agreeing on that fact. In fact, to try to establish that fact is often a good recipe for losing all your money. If you're shorted or losing all your clients if you're avoiding it. So I certainly take that point. Let me press further, though. So a lot of your research and this idea of market efficiency. But you've also worked on factors that seem over time historically to outperform. And so the idea of small companies outperforming big companies or value companies outperforming over time.

• 20:12Joe Weisenthal?

  Dimensional has funds that aren't just the pure market portfolio. Reconcile the existence of that with the idea of an efficient market.

• 20:22Speaker 04

  Okay, that's a good, that's a good question. So everybody has this confusion. The confusion is mixing together market efficiency and the dimensions of risk in portfolio selection. So going back all the way to Markowitz. We've all long known, for example, that people don't like variance. They don't like uncertainty about future returns. And they're willing to pay something to avoid it. So that gave rise to the Chaplin and so-called capital asset pricing model. In which sensitivity to the market was the measure of, was the measure of risk. So basically, it's a confusion of prices being reflecting value.

• 21:05Speaker 04

  And the story about what are the dimensions of risk in the market. So that's, that's a confusion that almost everybody seems to have. So a fish market doesn't say there aren't risk premiums in the market. Does not say that at all.

• 21:20Speaker 05

  One way to think about it is, you know, define the market to be all the stocks and bonds that are out there. Most of us believe stocks over the long haul have a higher return than bonds. But few people invest all their money in stocks. It doesn't mean stocks are inefficient, inefficiently priced. And just those are the market prices. And you look at different combinations of the two, and they provide different distributions of outcomes. And you just find that distribution that works best for you.

• 21:51Tracy Alloway?

  So a big chunk of the documentary is about the birth of passive investing and its connection with the efficient markets hypothesis. What's been the impact of the growth of passive investing on the market? Because we often hear that, you know, markets are reflexive, moves can end up impacting the market itself. And David, I think you yourself have argued that one of passive investing's biggest flaws is still very much alive, the index effect where stock prices go up a lot when a company is added to an index, even though everyone in theory should know that this is going to happen. And so it should already be priced in. How has passive actually changed the market?

• 22:32Speaker 05

  Well, that's an interesting question. First off, the kind of the impact of an index adding a new name, you know, causing temporary prices to go up. That's a temporary effect. It hasn't really impacted the long term investor very much. And one question that comes up a lot is, you know, if everybody indexed, you know, then there would be no price discovery and wouldn't markets become inefficient. You know, that's kind of. And my answer to that is, well, let's take a look at the behavior of the market over the last 20 years. There's been an incredible movement to indexing over that time period. And yet there's been an incredible increase in trading volume. I don't think of price

• 23:15Speaker 05

  discovery as being related to trading volume. So just because there's a big movement to indexing doesn't mean trading volume will decline. What's happened, unfortunately, is it turns out, like a lot of things that can be used for good, they can also be used for bad. And

• 23:34Speaker 05

  You know, index funds are the ideal market timing vehicle. I'll buy this healthcare index fund and sell my technology fund, or whatever it is. And I think that's really kind of what happened in the marketplace is it's kind of turned individual, instead of individual stock selection, it's kind of like a big gambling casino where you have a lot of different ways you can make your bets. So it doesn't look like, in terms of the basic notion of market efficiency, it doesn't appear to have had much impact on that.

• 24:06Speaker 04

  Let me just take a little different direction. And people worry that if everybody goes passive, how will prices get formed? And that's a legitimate concern. But then the issue is, who drops out? Who doesn't go active anymore? If it's bad active managers, people who have no special information, if they drop out, then you need fewer good active people to keep prices in line. So it depends on who drops out as to whether it has any effect at all on market efficiency. Now, we haven't been able to discern anything like that in the behavior of prices, but that is the question.

• 24:47Tracy Alloway?

  Since we're on the topic of indexing, you know, the market nowadays, as you mentioned, is basically defined by benchmark indexes, things like the S and P 500 or the MSCI World Index. And the benchmark index providers will often say that they're just holding up a mirror to the market as it exists, they're neutral. But it seems kind of obvious to me that their decisions do impact the market and some of those decisions can be subjective, you know, when it comes to measuring things like liquidity or how developed a particular bond market is or whatever. Are we just outsourcing investment decisions to index providers?

• 25:28Speaker 04

  You have to choose the one you want. So my own taste runs in the direction of a total market index being a good choice for almost everybody. So I don't go for the subset things that 30, whatever, 30 Dow Jones, that was always kind of dumb. But, or even the S and P 500, that's only 500, there's a lot more stocks out there than that.

• 25:54Speaker 05

  Let me just recoil against the term passive, you know. In my view, there's no such thing as passive management. And you're getting your Touching on something right there, you know, the different index providers and how they do it and they'll do it differently and so forth. And, you know, Standard and Poor's, when it wants to add stock to its S and P 500, you know, the investment committee sits around and talks about, you know, what do you like? You know, it's the S and P 500 is 500 of the largest companies, but it's not the 500 largest companies. And there's quite a bit of subjective judgment goes into deciding what, what stock goes into the index, which,

• 26:36Speaker 05

  if you're going to an index fund because you don't like stock selection, that's not the kind of activity you want to, you want to see.

• 26:43Joe Weisenthal?

  I want to go back to this idea of even if markets are efficient, there still are risk premia and certain asset classes are expected to go up more than others due to people's wanting to avoid drawdowns, et cetera. You know, like, I don't make many active decisions. I'm like a good, like, I follow what I read in the news and I like have some stocks and, you know, probably have some treasuries and some fund or something like that. And I don't like pay attention to it much. Looking back, though, at historical trends in portfolio construction, I sometimes wonder, why should anyone own bonds? Because you say hardly anyone just owns stocks, and that seems to be objectively true. But I wonder if like,

• 27:26Joe Weisenthal?

  is there a reason to question some of this dogma of like, why, like, if I'm not going to retire in 30 years, do I care about, you know, I'm already diversifying over time because I make an allocation to my retirement funds with every paycheck. So I'm already getting time diversification. Are there fundamental questions in portfolio construction that you think need to be rethought? If over the next 30 years before I can retire, 25 years, maybe, like, if almost everyone thinks it's certain that stocks will outperform bonds, why am I holding bonds?

• 28:02Speaker 04

  That's not, that if almost everybody thinks that's true, but it's not true. Stocks don't get less risky in the long term. Risk accumulates. So.

• 28:15Joe Weisenthal?

  Wait, I don't understand that. I don't, I don't understand how.

• 28:18Speaker 04

  The risk is when you retire, when you retire, there'll be a period when stocks have done particularly poorly and you'll, you will get hurt. That's always a possibility. It doesn't go away with time. So the presumption is is what's incorrect. The risk is always there. You don't get rid of it.

• 28:36Tracy Alloway?

  Hmm. What do you think about the term smart beta? And is dimensional doing smart beta?

• 28:45Speaker 04

  Yeah. Smart is a marketing term. Show me a dumb beta.

• 28:52Tracy Alloway?

  I'm sure I could find some examples, but they certainly wouldn't have set out to create dumb beta.

• 28:57Speaker 04

  There's a lot of, remember, there's a lot of marketing in the financial business. That's one of them. That's one of the big ones.

• 29:03Joe Weisenthal?

  Well, what does it mean to you? So like when you hear that term, like what is the person trying to sell to me?

• 29:09Speaker 04

  Well, you have to give me an example because I don't take it seriously, obviously. You can tell by me checking, yeah.

• 29:14Speaker 05

  Well, I think it's Gene's research that he did with Ken French.

• 29:19Joe Weisenthal?

  Yeah.

• 29:19Speaker 05

  His landmark 92 paper on called Cross Section of Expected Returns. Anyway, that, you know, kind of gave empirical support to the idea that there can be many dimensions of returns. So if you focus on a certain dimension, some people came up with the term smart beta. It's not smart. I mean, just it's just, you know, a reflection of the research and the dimensions of returns, you know?

• 30:03Speaker 01

  This is the Bloomberg Tech Minute brought to you by ChatGPT. I'm Carol Muster. Getting hired at SpaceX requires exceptional ability and may include having Elon Musk review a candidate's resume. So writes Bloomberg Business Week's Lauren Grush. She reports that the company culture is defined by Musk and job candidates must understand that a commitment to SpaceX means adhering to this culture and exhibiting loyalty to Elon Musk. To get hired, candidates must demonstrate their achievements from past jobs and hands on experience matters more to recruiters than advanced degrees with the company looking for people with raw, innate, intact. Intelligence. A spokesperson for SpaceX didn't respond to a request for comment on its recruiting and hiring practices.

• 30:46Speaker 01

  But according to recruiters, advisors, and those who've interviewed for jobs there, it's the space exploration dream that draws people to the company. And Musk invokes that dream regularly to remind workers why they're there. Prospective hires are told that the job will require stamina, including in job ads that candidates quote "must be willing to work extended hours and weekends as needed." One major perk for all that hard work? Employees' access to equity, either the right to buy shares or payment in the form of restricted stock units that vest over time. That's the Bloomberg Tech Minute, brought to you by ChatGPT. Get started at ChatGPT.com.

• 31:26Joe Weisenthal?

  Something that I'm really interested in when it comes to markets, particularly, I would say, over the last 15 years since the great financial crisis. Small caps have certainly not provided any sort of superior risk-adjusted returns to large caps. And you can see that on basically any chart. And growth companies, year after year, you know, by the traditional metrics of what we call growth and value. And I know people sometimes try to redefine these to allow them to put Nvidia in their value fund. Clearly, growth has been outperforming for a long time. And part of the reason it seems very obvious to me that these big tech stocks have done so well

• 32:08Joe Weisenthal?

  is because the companies have all done extraordinarily well in beating earnings expectations year after year after year. Does this pose a problem for a sort of factor-oriented investor? When the fundamentals of one sector, the real fundamentals, not the stock performance, produce these abnormal periods of profitability growth?

• 32:32Speaker 04

  Well, I don't know how abnormally they are. So the essence of all these dimensions of returns is that there is key. There are the results are highly uncertain over any finite period of a very period of time. So they came to poorly for long periods of time. They can also go away. If there's too many people jump on things, it can cause them to go away. So it's possible, for example, that interest in small stocks and interest in value stocks kill the size and the value premiums that existed in the historical data. It's quite possible. Pricing of securities is no more than supply and demand. So if the if the demand goes up and the price goes up with it, then you can see these premiums disappear.

• 33:17Speaker 04

  It's very difficult to unravel the story and the data because there's so much uncertainty associated, so much volatility associated with prices and returns. But these are always possibilities that these dimensions of risk are no longer compensated because people don't fear them anymore. They jump into them if they think the returns are better. That's always been a possibility. Ken French and I pointed that out in the initial papers we wrote on the dimensions of risk.

• 33:48Joe Weisenthal?

  So just to press on this point further, small companies are always going to have certain types of risks. Low liquidity stocks are always going to have certain types of risks that don't exist in high liquidity stocks. But when you think about these factors, these do not strike you as iron laws of how markets work, that you will at some point get compensated for taking on these risks into your portfolio?

• 34:16Speaker 04

  Well, you're mixing in trading costs there. So there are differential trading costs in different kinds of assets, differential transactions costs. Those are part of what you pay in a play, play the game in principle, they detract from the price of the prices of the stocks. But I'm not sure about what your question was, actually.

• 34:38Joe Weisenthal?

  Basically, the idea that at any given point, you will be compensated for the risks of smaller, less liquid stocks, that's not a necessarily a permanent characteristic of the market.

• 34:51Speaker 04

  Well, it was always, there was always a dimension of risk, which means this volatility associated with it. So historically, during the periods when on the over the long term, small stocks did very well, there were always periods when they didn't. Within those periods, within the periods of good, good, good returns. So that's always true. So there have always been periods when stocks did worse than than bills. There was a long period of that in the 30s, 40s, all the way up to the 50s. So these are just dimensions of risk and return, basically. And risk means you can lose.

• 35:27Speaker 05

  Well, I may also point out, in kind of the direction you're headed is, what we believe is, at the end of the day, you need to come up with sensible portfolios and well diversified, low cost and so forth. And when we started the firm, you know, we built it on the idea that you ought to have large and small cap stocks in your portfolio, not just large cap. Our first clients were large institutional clients and they were only holding stocks of bigger companies because they were trying to, they hired managers to outguess the market. And you can't build a business, much of a business, trying to pick the winners of the small caps because you can't buy enough of them to create a profitable business, or it's

• 36:10Speaker 05

  hard to anyway. So the thrust wasn't so much that we guarantee you higher returns. The thrust is you ought to have a well diversified portfolio and, in our view, not include a significant chunk of small cap.

• 36:24Tracy Alloway?

  David, you highlighted earlier the importance of data in modern finance and that definitely comes through in the documentary, the idea that a lot of these studies and theories went hand in hand with the development of, to Jean's point, you know, computers and the ability to actually track more information and crunch it more efficiently. Nowadays, it kind of feels like we're drowning in data. Almost everything is tracked. There's artificial intelligence, generative AI, all this stuff we could use. Do you see any new interesting ways of using that data or any interesting ways that data is being translated into either new financial theories or investment strategies?

• 37:09Speaker 05

  Well, you know, in Jean's view is the market reflects all available information. That's kind of the implication of efficient markets.

• 37:19Speaker 05

  And with these AI programs and so forth, I mean, they have vast amounts of data, but no AI algorithm can reflect all available information. So even though they have lots of information, there's still lots that get reflected seemingly in stock and bond prices.

• 37:36Speaker 04

  Looking at it from the academic side, what's happened with the coming of so many big databases that people do lots of research is that researching finances expanded. There used to be just a few of us doing it in the sixties and seventies. Now we have big finance departments in almost every school, all with people who want to do work. Most of it are work on, lots of it work on, on markets. So where there was one, basically one journal in the, in the sixties, it was, it all opened to this kind of stuff. Now you have four or five of them that are all, all pretty good, you know, coming up with new stuff, publishing three or four times a year.

• 38:19Speaker 04

  So there's been an explosion of research and uses all these new data. And that's been to the plus, I think. I really, I, when I talk to my young people, I say, boy, in the old days, it was easy when I was coming up, it was like shooting a fish in a barrel. Nobody was doing anything. So everything you did was new. Now it's much more difficult. There's much more precedent about what's been done and what, what hasn't been done.

• 38:43Joe Weisenthal?

  You started this conversation by talking about your initial problems, which is that when you're identifying historical patterns, it's easy to find something that works in sample and then it doesn't work out of sample. So I could probably come up with some story that tickers that start with the letter P tend to outperform on Tuesdays. And I could find some chart that shows that absolutely for years and years and years is the case. And then of course, you know, that's totally made up. And so then it doesn't work. And we've seen this explosion of other factors. So you have your three factors, but people are coming up with all kinds of factors and you've added factors, et cetera. When do you say like a factor loses legitimacy? It's like, you know what?

• 39:28Joe Weisenthal?

  This was P hacked. This turned out to be, it turned out that actually it doesn't really work out of sample after a long enough time. And in my mind, I am going back to say value versus growth or small versus big here. Is there a period at which if growth keeps outperforming value, you say, actually, that's not a real sustainable factor. It's not mean reverting. And this was a, the appearance of these excess returns was a function of limited sample size.

• 40:00Speaker 04

  Ah, okay. So Ken French and I have always been very sensitive to exactly this, this problem.

• 40:05Joe Weisenthal?

  Yeah.

• 40:05Speaker 04

  So every time we did a paper that seemed to have a new result discovered in it, we would consciously extend the data backward in time and see if the same pattern were, were observed. And then we'd go international and see if the same pattern was observed in, in other markets. So we were very sensitive to the precisely the issue you're raising. And it's a very important issue. Not many people do that. They don't look at out of sample data to see if it worked there. Now, we only went forward when we found things that seemed to work back, looking backward in time, which is one way of going out of sample and looking across markets, which is another way of going out of sample.

• 40:45Speaker 04

  But still, it's possible that the discovery of the, the effect causes people to move through it, to do stuff that basically makes it go away.

• 40:56Joe Weisenthal?

  Hmm.

• 40:56Speaker 04

  And it takes a long time before you can tell that that's true because of the basic nature of the uncertainty of the whole process, the amount of uncertainty there is about the evolution of prices. There's really no way to get around that. So we won't know how life, in my life, well, my lifetime anyway, but only six years old. We won't know in my lifetime whether the value premium or the size premium has, have actually gone away because you still don't have enough data to come to that, to come to that conclusion.

• 41:25Speaker 05

  Well, also let me add one, one additional thing to when Gene and Ken did all this great research. And they, they have the data there that jumps out at you. Then the, one of the questions was always, why would it be there? And you can go through the algebra on why low price stocks have higher average returns than, than high price stocks. It seems sensible that there would be, that low price stocks might have higher expected returns because it may be because they're riskier.

• 41:56Tracy Alloway?

  Gene, towards the end of the documentary, just on the notion of going forward, you kind of talk about what's next in modern finance and you make the point that we are not making these sort of quantum academic jumps as we did in the 1970s and that someone needs to come up with a new innovation, a new burst forward, but you don't really know who that might be. Do you have any sense of where people should be looking for the next big thing in modern finance or modern financial theory?

• 42:33Speaker 04

  That's again, excellent question, but I think the answer is all that stuff is basically unpredictable. You don't know where the new direction is until somebody discovers it. And where people think it might be, almost always turns out to be the wrong place. Not that you shouldn't do it, but simply it's a very difficult task. So the question is excellent. The answer is unavoidably vague.

• 43:03Tracy Alloway?

  Fair enough.

• 43:04Joe Weisenthal?

  There's nothing if a young student came to you and said, hey, I'm looking, you know, at 86, you might not want to dive into something new, but there's nothing. He's like, oh, I'm sort of curious about that. You should try to pursue a, write a paper. There's nothing that comes to mind that sort of you would suggest a young researcher make a stab at?

• 43:24Speaker 04

  Well, the question we started with was, what's the next big

• 43:28Joe Weisenthal?

  Yeah, right, right. Okay.

• 43:29Speaker 04

  Change the world?

• 43:30Joe Weisenthal?

  Yeah.

• 43:31Speaker 04

  That's much more difficult than saying, what's the next research wrinkle that we can do to extend, that extends the world a little bit?

• 43:38Joe Weisenthal?

  Fair enough.

• 43:39Speaker 04

  That's mostly what goes on in research. The small little steps forward and sometimes little steps backwards. That stuff doesn't work out.

• 43:48Tracy Alloway?

  Since we have Gene Fama here, I cannot resist asking a sort of thought experiment question, but what would be an EMH interpretation of the cryptocurrency market? Can you look at it through an EMH lens?

• 44:03Speaker 04

  I was wondering when you're going to come to that, but cryptocurrency gives me all kinds of problems because like Bitcoin is the only one I'm roughly familiar with, but.

• 44:15Speaker 04

  Nobody can explain why it survives because basically it's the old monetary theory says that something that has a highly variable real value can't be used as the the medium of of exchange because people won't want to deal with it. So for example, a business that doesn't want to do business in terms of Bitcoin because the variation in price of Bitcoin itself can knock the company out of business. So then the question becomes, who does want to use Bitcoin? Historical monetary theories, I learned it, is not capable of answering that question. So it would have predicted, and I'm still predicting, it'll bust it. It'll bust at some point. People will say, no, that's it. And they'll stop

• 45:00Speaker 04

  piling, piling into it. And then the market, that market will disappear. But we'll see. If it survives, we need a whole theory to explain how and why.

• 45:10Tracy Alloway?

  That sounds suspiciously like you're saying it's in a bubble.

• 45:14Speaker 04

  Oh, that's, I'm hoping it's in a bubble, is what I'm saying.

• 45:21Speaker 05

  Well, I think it may be that he's also saying that if crypto is going to survive, it'll be because it has some value right now. And it could, maybe someday, you can do transactions cheaper than you can with Mastercard or something.

• 45:39Speaker 04

  That's, that's, that's, that's a good, good point, because there's a difference between the medium of exchange and the method of exchange. So the method of exchange is how do you carry out the transactions? The medium of exchange is what do you put into it in order to carry out the transaction? So the question is about the methods, the methods evolve all the time. So we have a central bank method now that we use pretty much for every, everything in the US. But the blockchain is an alternative kind of mechanism. What you put into it can be anything. It can be, it can be Bitcoin, or it can be dollars. Doesn't really matter. So those are two, two different things. So people worry that a system where

• 46:25Speaker 04

  A central bank manages the transactions, which is the system we have, is too open to manipulation by the government, and the blockchain avoids that. But then it turns out that the blockchain is not scalable. Its complication goes up basically exponentially as it handles more transactions. So that's not the answer to the method of exchange problem. And that's something people are struggling with.

• 46:55Tracy Alloway?

  All right, David and Jean, we're gonna have to leave it there. But thank you so much for coming on Odd Lots. It was a real pleasure to speak with you both. And congrats on the movie.

• 47:04Speaker 05

  Okay, great, thanks. It was really a lot of fun.

• 47:19Tracy Alloway?

  Joe, that was really fun. Fama especially was someone I always wanted to speak to. I do have to say, you know, I mentioned earlier, the way you feel about the term premium is probably the way I feel about the efficient markets hypothesis. And I recognize it's a theory that exists. But I guess I'm not sure how useful it is to basically say that the average investor can match the average return of the market. Like, does that lead anywhere?

• 47:45Joe Weisenthal?

  Yeah, yeah, it absolutely leads somewhere. It means that you almost certainly shouldn't try, and that if you try, you will probably end up making mistakes.

• 47:55Tracy Alloway?

  It's such a depressing view of human capability.

• 48:00Joe Weisenthal?

  I think this is one of the most useful maxims in finance, because even if it's not formally true, right? Even if there are slight variabilities, et cetera, I do think it seems very clear that the vast majority of people, including many professionals, as the statistics have borne out, like, can't actually generate superior returns. And so if the only thing that we like, if the only use we get out of the efficient markets hypothesis is like, do something else with your life than trying to beat the market, that sounds like one Careful advice that I think most people should heed.

• 48:37Tracy Alloway?

  Should you say that on the All Thoughts Podcast?

• 48:39Joe Weisenthal?

  Well, that's the funny thing. It's like, why are we all here? I mean, this is like the existential question of everything because like my interpretation of Jean's answers is basically a recurring series of, yes, it's priced in, yes, it's priced in, yes, it's priced in, yes, it's priced in. And so I do have this existential question about we support this news organization that supports an industry. And I talk about this stuff all the time. And then it's like, why?

• 49:09Tracy Alloway?

  I think I'm closer to David's position on this where, you know, true passive doesn't necessarily exist. There's sort of a middle ground where you can have systematic approaches, but you're still making active decisions in the way you either execute trades or, you know, in the cost of your investment and things like that. I think that's a reasonable middle ground. I am not sure. I am in EMH fundamentalist camp just yet, but maybe you can convince me.

• 49:38Joe Weisenthal?

  Yeah, you know, here's what, here's my, this is not the weak form. There's a definition of the weak form efficient market hypothesis. What I would say is this, and I've actually given this advice to other journalists. And I think this is something that I could try to convince people of, which is that if you look at the market and you think that you identify some security or anything that seems to you obviously mispriced, you should start with the presumption you're missing something. It's very unlikely that you've just seen something in the market that obviously you can profit from. It occasionally happens and people have a thesis and something looks clear and they make a lot of money. But I think most of the time, if you see a line, you're like, it shouldn't be there.

• 50:23Joe Weisenthal?

  You should start with the assumption that the billions of dollars flowing through the market didn't all miss something that you see as obvious.

• 50:31Tracy Alloway?

  Yeah, but there are people who outperform the market and it's a little bit like. Again, tautological, I guess, just to hand wave it away and be like, oh, they got lucky.

• 50:41Joe Weisenthal?

  Yeah, right. But can you identify the people who, right? This is the problem, like, right?

• 50:46Tracy Alloway?

  Yeah, no, this is it.

• 50:47Joe Weisenthal?

  And this is why, this is why it's all these things break your brain.

• 50:50Tracy Alloway?

  Lucky in choosing the lucky investment managers. How about that?

• 50:53Joe Weisenthal?

  I mean, that's right. That's like, I mean, that's like, you know, manager selection suffers from the exact same problem as stock selection, the out of sample, in sample bias. This is why, but one thing I am curious, like, when we are long dead and maybe the Odd Lots franchise is so valuable that there's like, you know, there's like new hosts of the podcast, right? Because they want to continue it. Maybe they'll be alive long enough to say like, oh, turns out there's no small cap premium. After all, because Gene opened up the possibility that, yeah, we, all of finance and economics suffers from the tragedy of small sample sizes. Like, it's like this known phenomenon, like, the world is just getting started. Maybe one day it'll be like, ah, actually

• 51:36Joe Weisenthal?

  it turned out that wasn't really a thing, but that'll probably be after all of our lifetimes.

• 51:40Tracy Alloway?

  In the long run, we're all dead. Since you mentioned.

• 51:43Joe Weisenthal?

  In the long run, all factors.

• 51:44Tracy Alloway?

  Yeah, are dead.

• 51:45Joe Weisenthal?

  All factors suffer from sample bias.

• 51:50Tracy Alloway?

  Since you mentioned the small cap stocks, there was this little visual in the documentary where they showed a headline from, I think it was the early 1990s, and the headline was mutual funds offbeat theory by stock in smaller firms. And I thought that was so funny and kind of quaint, because they're basically talking about growth stocks. And, you know, nowadays, growth stocks are sort of an accepted idea. But back then, it was offbeat, an offbeat theory. And it kind of shows just how much financial theory is embedded in the market now that we take for granted. But, you know, a decade ago, or two decades ago, or five decades ago, people didn't know it.

• 52:31Joe Weisenthal?

  Well, and just on this one point, it is interesting to that now if someone says growth stocks, you think really big companies.

• 52:40Tracy Alloway?

  Yeah.

• 52:40Joe Weisenthal?

  And there was a time when if someone said growth stocks, you'd think about really small companies and that big companies were supposed to grow slowly. And so this is kind of what I wonder about, like these like are fundamental realities of business changing and could those fundamental realities of business changing change fundamental aspects of the stock market because we now have this era where you have gigantic companies still putting up growth numbers that in any time would be incredible.

• 53:07Tracy Alloway?

  All right. Shall we leave it there?

• 53:09Joe Weisenthal?

  Let's leave it there.

• 53:10Tracy Alloway?

  This has been another episode of the Odd Lots Podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway.

• 53:16Joe Weisenthal?

  And I'm Joe Weisenthal. You can follow me at the Stalwart. Check out the new Errol Morris documentary, Tune Out the Noise, that talks about all of these things and the beginnings of modern finance. Follow our producers, Kermit Rodriguez at Kermit Armadas, Joe Bennett at Dashbot and Kell Brooks at Kell Brooks. For more Odd Lots content, go to Bloomberg.com/oddlots, where we have a newsletter, our episodes and a blog. And you can chat about all of these topics, including endless circular discussions about market efficiency in our Discord, discord.gg/oddlots.

• 53:51Tracy Alloway?

  And if you enjoy Odd Lots, if you like it when we in fact have an endless discussion about the efficient markets hypothesis, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad free. All you need to do is find the Bloomberg channel on Apple Podcasts and follow the instructions there. Thanks for listening.

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