tv Best of Bloomberg Technology Bloomberg November 9, 2019 11:00am-12:00pm EST
narrator: eugene fama is widely regarded as the father of modern finance. eugene: there is no behavioral finance. barry: wait, say that again? eugene: there is no behavioral finance. narrator: the nobel laureate who has been at the university of chicago since the 1960's and educated thousands of students. one standout assistant who worked with fama in the early days was dimensional funders cofounder, david booth. david: we had a belief in
markets and how they work based on how we study them here. look, we think we can go out, trading stocks, and not get killed. their relationship now extends five decades and led to the beginning of dimensional, a nearly $600 billion institutional fund manager. david: every new paper coming out was a landmark paper. it was all brand-new stuff. and none of it was being applied. narrator: the two recently sat down at the university of chicago booth school of business, named after david a widespreading renovation in 2008 for a wide-ranging conversation with very on a very special "masters in business." barry: during your last year at tufts, you worked for harry ernst, who had a side gig running a stock market forecasting service. and you did research for him. what sort of work did you do with this stock forecasting research?
eugene: i was evaluating schemes to beat the market. [laughter] barry: and how did that work out? eugene: it worked out fine. [laughter] eugene: on the data that i fit it to. it didn't work out fine on the whole sample. never did. that was a lesson in picking up things that aren't really there. barry: and how did that research into forecasting the stock market impact your thinking about whether or not the market -- could be beat? eugene: well, when i came here to chicago, research on asset prices had begun to get going in a very serious way. many people were interested in the question of how well stock prices were adjusted to new information. put in context, they say it started because of computers. before 1960, we really didn't have a serious computer to do data analysis on. with the coming of computers, statisticians and economists had
a new toy to play with, and stock prices were easily available. so that was one of the first things they started to study. and immediately, the economists said well, how do we expect prices to behave if the world was working properly? in other words, if markets were efficient. they were not using that term, but that is what they were after. there were all kinds of theories proposed that had lots of in acomings to them, and little bit of time we came to the efficient markets hypothesis. barry: and you were in your senior year at tufts. you had applied here but never heard back from the school? is this an urban legend or it's true? eugene: no, it's true. [laughter] barry: so what happened? eugene: i called, and the dean of students, jeff metcalf answered. that wouldn't happen today. the school is so much bigger. the dean of students doesn't even have a telephone. way too important for that. so he answered the phone and
chatted for a while. and he said, we don't have any record of your application. what kind of grades do you have at tufts? you need pretty much all a's. he said, i have a scholarship for someone at tufts, do you want it? [laughter] eugene: that's how i ended up at the university of chicago. [laughter] barry: you come here as a student, you're finishing your work. myron miller says to you, you want to stick around and do the sort of research you are doing? is that how you became a professor here? barry: yeah. i had offers at some other places but most of the turned me down. they said i was to chicago. [laughter] eugene: i don't know what that meant, actually. barry: these folks know exactly what that means. [laughter] eugene: it was very weird to hire somebody from your own phd program on your faculty. they had only done one or two before that. barry: so david, you had a different experience.
you grow up in kansas, get a ba in economics and a masters from the university of kansas. what made you decide to come to chicago? david: i did a little bit of reading in finance. a financei had professor there that got his phd here and he said, finance is exploding, really emerging as an academic discipline. one of the epicenters is clearly chicago, so i thought well, that would be fun. maybe i could be a professor. so i applied here and started to study. i took gene's class my first class. barry: was the dean correct? 50 years ago? eugene: yeah. 50 years ago this fall. it was the first year chicago had a football team in 34 years. [laughter]
barry: and you had written about your experience taking a class with gene. you called at life-changing and transformative. in what ways was at life-changing? david: well, life-changing, it led to a career. i mean, can't have much of a bigger change than that. life-changing, everybody here probably would like to think of themselves as having a public purpose. at the end of it all, when you get to be my age, you want to look back and think somehow the world was better for having been here. so, these ideas that were coming out, the essence of efficient markets was already well developed. he had already coined the term. and it was enormously useful. you look at the way money was managed 50 years ago, people were getting ripped off. i mean, fees were way too high. commissions were fixed by the government at about 10 times
what they are today. barry: well, it's free today, so it's a lot more than gen x. david: yeah, yeah. so it's -- i think there was a -- we can improve people's lives, a real purpose to all of this. gene, more on the research side. i thought my role in all this would be more on the application of the ideas. barry: so you become gene's teaching assistant. how did that come about? eugene: i always pick a student in the class. from the previous year to be a teaching assistant. barry: good student. eugene: he was the best in the class. [laughter] david: you don't have to laugh at that. [laughter] barry: so, that student, 's teachingama assistant, why not a career in academia? david: first off, i realized i
could not compete with gene. top of the mountain. but it is really something that caused me to reflect really and determine what am i about? what do i enjoy? i just saw this as a great opportunity to apply all these ideas. people were developing. every new paper coming out was a landmark paper. it was all brand-new stuff. and none of them were being applied. barry: so we're going to come back to the application shortly. but you mentioned these new groundbreaking papers were coming out. professor fama, your doctoral thesis in 1964 was the behavior of stock market prices. and this sentence jumps right off the page -- "chart reading, though perhaps an interesting pastime, is of no real value to the stock market investor." so this gets published in the journal of business in 1965. what sort of pushback you get
-- do you get from the general concept that charts are of no use, past market plots are of no future pretty debility -- future ity going forward? eugene: got a lot of pushback. academics looked at the data, what they were saying, what they were showing, and adopted it right away. david: i mean, if you had to summarize, really, the impact of all this, what was going on in chicago then really changed the way people think about investing. and that has really been the theme. and gene has changed the way people think about investing. barry: that's the pre-and post line, pre-fama and post fama? david: yeah. barry: there is a sea change -- eugene: wait, i don't like the post-fama business. [laughter] barry: meaning post publication of your work.
[laughter] barry: so we not only have your doctoral thesis, we have the efficient market paper, the fama french three factor paper. there were a number of very, very influential papers that david, if i'm hearing you correctly, you are saying that changed firmaments of finance forever. david: change them forever and for the better. particularly in 2019, among students, there's this antipathy towards finance and economics. you know, and they don't realize finance has changed for the better. people's's lives have been improved by these ideas and this research. lower fees, better risk control, and so forth. eugene: truth is, prices are so volatile, markets are always looking really efficient. they don't look any more efficient than they ever have with the introduction of the new
barry: back in the days when active managers were dominant, inefficiencies could still be easily found, as could 2% fees. professionals didn't believe markets were efficient. they thought they were kind of sort of eventually efficient. i doubt many of them would say that today. what do you think has changed to bring so many people over to the efficient market theory? eugene: well, accumulation of performance evidence. so back then, there was no real evidence on how these people did. one of the first papers was mike jensen's thesis here, which studied mutual funds for the previous 25 years.
and so basically they weren't beating the market. now we know, in hindsight, that has to be true. that active management is a zero-sum game before cost because they can't win from the passive managers because the passive people hold cap weight portfolios. they don't overweight and underweight in response to what the active people do. weightingy under and overweighting has to be oning an active manager the other side, doing the opposite. if one wins, the other loses. some of those is zero, before costs. the arithmetic of active management. he calls it the arithmetic because it is arithmetic. it's not a proposition. it has to be true. barry: for every winner, there's a loser. eugene: right. barry: what about technology? how does that impact how fast it
makes its way into prices? eugene: it should make it better. but you know, the truth is prices are so volatile, markets have always looked really efficient. they don't look any more efficient than they ever have with the introduction of all the new technology. so information is spread much more quickly now than it was 50 years ago because you have so many sources and they're so quick. can't really see in the data it's had a quantum effect on the adjustment of prices to information. barry: so, we may not see it explicitly in the data, the when -- but when we look at hedge fund performance, they did well before the financial crisis. since then, not as well. we look at the money flows away from expensive active towards inexpensive passive, it sounds like lots of investors are voting with their dollars that
hey, the market is efficient and we can beat it. doesn't it seem like technology's driving some of that? because there used to be information asymmetries. there used to be inefficiencies that a manager might have been able to find. sounds like it's even harder to find those inefficiencies today than 30 years ago. eugene: you have better information than i do. because it's always been hard. barry: it's always been that way? eugene: it's always been a zero-sum game. david: i've been in the business almost 50 years. every year people say next year is going to be the stock pickers market. what gene's saying is it's is arithmetically impossible. barry: so let's talk about index funds. gene, you introduced david when he's finishing his mba and was wanting to go out in the world to work, to john mcgowan at wells fargo, where they were
developing as an institutional product, the first index fund. what made you think that that was a good fit for david? eugene: oh, well, the man who was in charge of the wells fargo unit, came to all of the seminars we did here for business people. we did them twice a year. seminars and security sessions for interested businesspeople. he came to all of them and seemed very into the new stuff. so when it came time to say david, i want to see what you can do but i don't want to do it. [laughter] barry: as an academic. eugene: right. i would work here if you had a place for me, and needed. barry: what was your experience working on that wells fargo index fund? david: terrific experience. great exposure. i learned the importance of client work. i mean, investment business is part technology and part client
work. as i've told gene, i studied finance for two years. been studying client work for the last 48. david: we got into all the stuff, but we had an easier argument, which was look, we ought to hold a large company, then small, and you're not holding small. you need access to small. so that was really the sales pitch that put us on the map. ♪
-- to run the portfolio like an index funds, although at first we called it an index fund, because it is very similar to indexing, with the final step being that we don't trade market on close like many indexes do. and what that means it is, we would be trading stocks around the day. well, that created a lot of skepticism, particularly among academics. as you're going to the marketplace, you know you don't have any undiscounted information. people on the other side of your trade, largely institutions, think they know a lot about the stock. why won't they just rip your eyes out when you're trading? that's a legitimate question. barry: so what's the answer? david: well, the answer is there's a lot of things you can do to use the energy of markets and the power of markets to your advantage. it turns out, for example, if we want to buy a stock, let's say, an institution wants to sell it,
their anxiety is greater than ours, so we can use that. their interest in trying to do a quick trade can help us protect ourselves. there's plenty of information outflow data about the stock you can use to protect yourself. but that wasn't known back then. it was just we had the belief in markets, believe and how they -- believe in how they worked based on what we study here and said look, we think we can go out and trade these stocks and not get killed. eugene: there were two theses done here on returns, and most of the academics, as well, looks good in terms of the crisp, historical data. trade it, tried to you are to get swamped by trading costs and those so-called micro market things. and then we figured out what dimensional was. you didn't have to pay those
spreads you are seeing. you could do better with the prices, so we could deliver the small stock premium. barry: but previous to that, people weren't able to -- eugene: they couldn't believe it. what the academics learned is the micro sector stuff was garbage, basically. david: interesting what we learn about clients along the way. in 1981, our initial clients were all large pension funds, the largest pension funds essentially, insurance companies around the world. and they weren't holding the stocks of small companies, so really the pitch, we got into all this stuff, but we had an even easier argument, which was look, you ought to hold stocks from large companies and small, and you're not holding small. so we'll give you access to small. that was really the sales pitch that put us on the map. barry: so that sales pitch starts to take off, and dimensional operating out of your apartment gets bigger.
there's kind of an urban legend that you called new york telephone to have them add six phone lines and they refused. they thought you were running a bookie joint. is that true? [laughter] atid: yeah, this was back the model of brooklyn heights. so so, we started on a -- so we started on a shoestring. i was the first portfolio manager of my bedroom. i knew we needed more phone lines. so i called up the new york telephone, which was the telephone company at the time. sixeed new telephone lines, or eight or whatever. they thought i was a bookie so they wouldn't give me the lines. so i had to call up the treasurer at new york tel and say, hey, can you send some people down here and give me some telephone lines?
some telephone lines? they went around the whole block and found that there were six lines available in the whole block, based on their equivalent. and they said ok, you can have those six lines. that's how we got started. barry: and the punchline is he becomes a client. david: yeah, right. new york tel was a client. barry: so, from day one, gene is a board member of dimensional funds from the day it launches. david: even before, the idea to start the firm. my first call was to gene. saying look, it's been 10 years since i was in school. there's been a lot of research. we need to have access to new research and thinking. and would you be one of the founders and be our eyes in terms of research? and he agreed to do that right away. barry: who else did you recruit from gsb? david: eventually, we wanted to
create a mutual fund. and the mutual fund has to have an independent board of directors. so wrecks and i went over to the business school, myron miller's office. still teaching around here or something. ok. so yadda yadda, small-company fund, need a company director. myron said oh, sure. walked out the door and down the hall. yadda yadda. gene's point, business school was a lot smaller than. and being in the phd program, you get to know the faculty pretty well. so myron agreed to join, so on and so forth. so until recently, all the independent directors of the mutual fund, our mutual fund had taught in chicago. eugene: and rex springfield was in my class, as well.
he was really the to put out an first one index fund, wasn't he? david: no, first s&p 500. rex, that was when gene was teaching. he took gene's class. he was a pain in the neck teaching assistant because he was interested in everything. barry: so gene, you moved pretty easily back and forth between academic theory and real-world application of theories. [laughter] barry: not a lot of people were able to bridge that gap between academics -- eugene: i hadn't been able to bridge it either until dimension al came along. barry: but here it is 40 years later. eugene: right. the reason i couldn't is because one, i don't take a partyline. and he didn'tever
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♪ barry: so let me fast-forward a couple of decades to the mid 2000s. in 2008, david booth made the largest donation ever to a business school which has been called transformational. tell us about your thinking. what made you decide to make a donation to your alma mater. david: it ties into the story we were talking about earlier. it got to be the stage where it was time to pay back.
i mean, i would not have been anywhere without chicago. i said i wanted to give a big chunk of what i had. barry: this is a mix of stocks and cash, correct? david: actually i did not have a lot of cash at that time. [laughter] we had just recently started to accumulate money. but i had stock in the firm and i gave them basically ownership of a big chunk of the stock i had. they were willing to take a bet on that.
turned out to be a good bet. barry: and that comes with a dividend which continues to pay its way. were you at all concerned that you were right in the middle of a financial crisis, giving ownership of a financial firm? a lot of firms did not make it through the crisis. david: maybe it ties in with the earlier question about what i learned about markets. in the depth of the financial crisis, you have to keep reminding people that markets are where buyers and sellers come together. a voluntary transaction both sides need to feel they have a good deal or they won't trade. a lot of well-known investors are investing. it was just one of those, markets were functioning the way they ought to. up.times they go sometimes they go down. barry: how did david's gift impact the graduate school of business? eugene: there was a lot of cash flow that was not there beforehand. [laughter] eugene: it gave rise to reachers -- research centers and made
everyone feel the future was more or less assured. the university also got a pretty good take out of it. they always do. [laughter] barry: david, you tell a charming story about sitting with the dean. it was not your intention for this to be a naming gift. they seem to have brought that up to you. david: for the reasons i outlined, i wanted to make a gift. so this is what i want to do. the dean at the time said, gosh, we were looking for a naming gift, and this is a lot better deal than what we were looking for. we will name a school after you. ok, whatever. [laughter] barry: since then, the school has continued to grow in both reputation and number of students. fast forward five years after
that, gene gets a phone call from sweden. talk about that. what was that experience like? did it manage to reach you? ls what that was like. it was early in the morning, right? eugene: it was stockholm time, which is early in the morning here. you never expect to get it because a lot of people could qualify to get it. the people here somehow had a guess or whatever. i don't know, because there were newspaper people at my door not 10 minutes later after the call. they wanted to come in my house. i said, no way. [laughter] i had a class that morning.
barry: you don't get a special dispensation? eugene: you could, but i had never missed a class and i was not going to start now. and i wasn't letting anyone in. the kids in class were paying a lot of money to take that course. no way i wanted people disturbing us. barry: david, you ended up going to stockholm. what was that experience like? david: of course, being chicago-trained, i had been to the ceremony before. you are kind of used to this. [laughter] barry: third time is the charm? david: i said to gene, give me a night to organize something special. abba has a museum in stockholm and i talked them into renting me out of the museum for the evening. gene has four kids, eight grandkids, they are all big music fans.
the museum has a lot of things you can do to have fun. ,ne of them is a big's danger and with the musicians singing and a microphone right in the middle. it looks like you are singing with them. the kids went wild. i looked over, and i could see they were having fun so it made it special for me. barry: some have described it as surreal. eugene: the day after, they had a big event at the school. it was with the news and everything. a lot of the circles around the building were full of students. the next day, the nobel people had a camera committee, follow
ing me across the harper center and the big atrium in the middle. students over on one side, we walked down the middle and nobody looks up. we get to the other side and the television guy says nobody looked up. i said this is the university of chicago, if they had to look up every time a nobel prize winner walked by, they would get nothing done. [laughter] barry: and to show you how true that is, we got in an elevator to come down here and a student gets in wearing headphones. does not say a word to either downu, and we all wrote it down ine all rode silence. he was completely oblivious to who was in the elevator with him. i am always fascinated by that sort of stuff. eugene: i am the most important person in behavioral finance. barry: you are? why is that. eugene: most of it is just criticism of the markets. so without me, what have they
barry: value has a tendency to go through longer periods, and for the past decade, if you weren't in big cap u.s. growth, you were underperforming. everything has been the s&p 500, when we look at emerging markets, small-cap, value, heaven forbid you are in emerging markets. it has been terrible. what sort of lessons should investors take from this extended period? eugene: the question they want to ask is if value is dead. i am writing a paper at the moment, but the bottom line is, there is so much volatility in
premiums, you cannot tell if the premium has changed. it may have or it may not. the experience is well within the range of chance over the time it has occurred. barry: there have been other times where value has done poorly. i remember hearing this value investor was washed up, this guy named warren buffett, he doesn't know what he is doing. usually, when you hear that, it is near the end of underperformance. you are suggesting we won't know for some time if the value premium is gone or if it is just a regular, cyclical underperformance. eugene: i don't think there are cycles to it. i think it is just kind of random. you go through good and bad periods. you can't recognize them until after the fact.
you cannot really predict them. we try predictive tests and they have marginal value. nothing worth focusing on. basically what you are stuck with the volatility of equity returns. they don't allow you to really say a lot about expected returns going forward. barry: david, we have seen a huge proliferation of various factor funds. there are now hundreds identified. what does this mean for investors? has the proliferation of these factors been good or is it a nonevent? david: on balance, it has been overstated, whatever it is. research has identified factors that seems to explain differences in average returns.
but there can't be hundreds of factors. at the end of the day, there are probably a few. gene and ken, they try to take the research out there and get it down to -- barry: factors that matter. eugene: a lot of these are just different manifestations of the same thing. value can be in many different ways. you can use the market ratio or different variables to identify what is basically the same thing. and there are thousands of finance professors out there who all want to get tenure. they have to publish to do that. so they are all searching through the data. they find stuff that may be there only on a chance basis. so there is lots of work being done and that remains to be done on what we call robustness.
how does it stand up with new data? we have always been into robustness in the sense that when we found the 92 paper, we went back to data that started at 63. we collected data back to 26. then we looked at international data. pretty much the same thing everywhere. now we have a bad period of this. but relative to all of that, it does not look that serious. barry: i have to ask you a question about behavioral economics. we are here in chicago where we could call it the birthplace of behavioral finance. what do you think about that area and what is your involvement? eugene: well, my good friend richard taylor, king of behavioral finance -- barry: and another nobel
laureate. eugene: i tease him and say i am the most important person in behavioral finance. barry: you are? eugene: i am. most of behavioral finance is just a criticism of markets. without me, what have they got? [laughter] barry: and you and dick taylor are golf partners. do you argue over 18 holes? eugene: we agree on the facts, we argue over interpretation. for example, he thinks the value premium is the result of misperceptions of what economic information looks like. it's all based on misinterpretation of information. if you believe that, you believe it should go away. you have to teach people they
have these biases so the managers be able to get past them. barry: but they still have emotional reactions that sometimes they can't get by. eugene: that's the thing about behavioral economics. what the studies seem to show is that people don't learn from experience. if you are stupid you are repeatedly stupid. [laughter] most people are stupid. barry: someone has to be on the wrong side of the trade. so you guys agree more than you might realize. eugene: we agree on the facts. barry: but not the interpretation. eugene: there is no behavioral finance. barry: say that again. eugene: it is all just a criticism of efficient markets with no evidence. [laughter] barry: is dick here? [laughter] i think he would disagree. eugene: i am not so sure. when i put the challenge to him, he wrote a paper that said, ok, you have been criticizing us.
time for you to come up with a theory we can actually test. barry: and what was his response? eugene: we are still waiting. david: actually, you presented that paper at ucla. gene walks in and says, on the way over, i was thinking of breaking my leg so i could catch some sympathy here. barry: to be fair, when taylor won the nobel prize, he admitted his plan was to spend the money as irrationally as possible. so even he agrees on that. i wanted to ask about some of your comments on beta. in 1993, you said beta is dead. do you still believe that beta is dead? eugene: the evidence says the relationship is too flat. it's a shame, because the model is so simple.
investment. you need some to make prices efficient. the problem is, you don't expect them to be professional managers, because the logic of being a good manager is you should get returns, you don't hand them to other people. that is of the human capital activity. if you have a real skill, you should be charging. barry: this is for both of you. what sort of opportunity for outperformance do you see in private markets given that that space is so much more opaque. eugene: the problem is there are lots of good people studying that, but they are hamstrung by the lack of good data on people who live and die. barry: it's not like funds were they have to report. eugene: you get a very biased set of data.
it depends on what end of that business you go to. managers basically run the companies they buy. they may be able to add value, but it is management value. you are picking companies that have a good idea of how it runs. you probably will have a lot of value added in that case. again it should go to the guys doing it. that's the downside of that. barry: they are the ones who take all the profits out of it. eugene: that is the logic of human capital. barry: i have to ask about bubbles. eugene: what do you mean by a bubble? barry: folks would describe a bubble as a period of excessive market enthusiasm that leads prices to outstrip their fundamental valuations.
eugene: the way i interpreted is you must be able to predict the end of it. a bubble must have a predictable ending. barry: so predictable parameters and being able to define the end of it. eugene: it fails the test every time. people can't identify bubbles that way. barry: until after the fact. eugene: after the fact is easy. there is a famous theory around the early origins of market efficiency. when he went into the faculty lounge at stanford, he showed charts of prices and said these were charts of commodity prices. he wanted to know if they could identify bubbles. they all could.
the problem was what he was showing them was cumulative numbers. so the message is people see bubbles where there are none. barry: here is a really broad question. given the societal angst of people attacking the value of a business education, what is your belief in the value of this education here at booth and how should we communicate this better to society? david: it is incredibly valuable to society because if we are to make lives better for people, part of the answer has to come from better and safer financial products. that has been the reality and that has been the history. as i said, i look back on my career working with gene. we have been part of the movement towards lower fees and better controls.
i find it irritating when somebody says the only advance has been the atm. barry: that was paul volcker's quip. david: yeah. based on all this work, we have improved lives. we are not the only ones. there have been other people sharing ideas. i think it is much better than that. i would hate to have people not get into business, particularly financial services. you can have a good career in financial services. at the end of it, you can look back on it and take pride in what you have accomplished. it's as simple as that. barry: that leads to the next question, what keeps both of you working? neither of you have to work. why do you keep going to the office every day? david: it's fun. it's fun to see retired people living better as a result of
these ideas. or being better able to send their kids to college or whatever. these are not ideas that have no importance. you can get behind this kind of idea. eugene: you get a lot of satisfaction out of coming out -- up with stuff people have never seen before. barry: we have time for one last question. i am going to go with something about what do you think the future of chicago booth looks like? what is next in store for the school? eugene: i have been on the faculty since 1963. a student since 1960. and in the 1960's, basically, there was a pretty good economics group and a developing finance group. that was it. the rest of it was junk.
barry: right. eugene: that was not unique to us. when i was recruiting as a student in college, the people recruiting said, why do you want to go to a business school? they do not teach you anything. that was true them at the time. true, at the time. but what has happened since then, not just finance, but every other area has been more successful. marketing, accounting, statistics was always good but never part of business schools. now we have really front rank faculty in every discipline. the school is so high-level competitive on the faculty and research side. there is no relation to what it was 50 years ago. it is totally different. on a student side, there was a challenge and i had been complaining about for a long