The Father of Efficient Markets: Is Warren Buffett Smart or Lucky?

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Eugene Fama, Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business, is generally regarded the father of modern finance.  Along with Ken French of Dartmouth, his research has expanded upon the capital asset pricing model to identify the value and small-capitalization contributions to risk.

Dan Richards spoke with him on May 1, the day before his guest talk at the CFA Institute annual meeting.

Videos of this interview are available here.

I’d like to begin with a paper that you and Ken French published in 2010 in the Journal of Finance relating to the long-term performance of active mutual funds.  What interested you in this topic?

It's an old topic, but we wanted to add a perspective on the overall performance of individual funds, in particular to what extent is performance due to luck rather than skill. So that is the title of the paper, “Luck versus Skill.”

We looked at US stocks, and the timeframe was 1982 to when the paper was published. Basically 1982 was the earliest period in which you have mutual fund data that is free of what we call survivor bias. In other words, dead funds are included in the data from then on. That's very important because a lot of funds die.

What were your high-level conclusions for that 30-year time period?

First, if you look the industry as a whole, and you take a dollar invested in active mutual funds in proportion to their net asset values – bang, right on the market. So, in aggregate, they are holding the market portfolio.  Their portfolio looks just like the market portfolio. It is correlated 99%-plus with the market portfolio, but their returns are under the market portfolio returns by almost exactly the average expense fees of the funds.

That's actually a theorem that applies to active investing in general. Active investing has to be a zero-sum game before fees and expenses. Now the mutual fund industry is not all active investors. But when you add up all active investors it is just arithmetic that says they have to add up to zero.

After fees and expenses, the industry as a whole loses to the market by the amount of fees and expenses.

Now suppose we look at individual funds, and we identify funds that have skill and funds that don't. Now, the implications of that simple statement we started with, what Bill Sharpe calls the arithmetic of active management, is that everything has to add up to zero. The implications of that are – and this is a little counterintuitive – if there are real winners, not just lucky winners, there have to be real losers.  The winners beat the losers.

And could you tell me more about how you conducted this study?

The trick is to form a population of returns that looks just like the actual population, except that you constructed it so that there is no performance, and you know in advance that all of the outcomes are due to chance. Then you do what is called a bootstrap simulation and construct returns for each fund. You compare the distribution of generated returns to the actual distribution, the cross-section of returns. We are looking at funds for their entire lifetimes, not five years or three years of performance.

What we found was if you give the funds back all their fees and expenses, you subtract their benchmarks out and then their returns are basically symmetric about zero.  The right tail is a little bit fat and the left tail is a little bit fat, in that there are more winners then you would expect purely by chance, but there are also more losers than you would expect purely by chance, and they balance one another.

So what percentage of active funds would be in that category that would appear to demonstrate skill?

About 15%, before fees.