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Applying the Teachings of a Nobel Laureate for Over 20 Years

By on January 4, 2014
Categories: D&Y UPDATES, INVESTING

Welcome to 2014!  We hope you enjoyed a wonderful holiday season! Stocks continued marching upward in the fourth quarter.  Despite modest expectations as the year began, the S&P 500 index of Large U.S. Stocks notched its best annual performance since 1997, with a 32.4% total return.  Small U.S. Stocks shot even higher, with the Russell 2000 up 38.8% for the year.  Even better, the gains came without the anxiety-inducing volatility to which we have grown accustomed in recent years.  Certain niches of the global stock market—Emerging Market Stocks and Real Estate Securities in particular—had more muted returns due to currency effects and rising interest rates.  Overall, 2013 was a stellar year for equity investors. In contrast, fixed income markets struggled in 2013, in anticipation of a tapering of bond purchases by the U.S. Federal Reserve.  Core short-to-intermediate-term bonds had their worst year since 1994, with a total return of -0.9%.  Over the course of the year, the yield on the benchmark 10-Year U.S. Treasury bond rose 72% from 1.76% to 3.03%.  While this has been, and may continue to be, a painful transition for bond investors, we must remember that in the long run, a return to more normal yields on fixed income investments is a healthy development and will provide higher levels of income in the future. The following are asset class returns for the quarter and full year:

Index Asset Class Fourth Quarter 2013 Full Year 2013
Barclays Capital U.S. Int. Government / Credit Index Fixed Income 0.0% -0.9%
S&P 500 Large U.S. Stock 10.5% 32.4%
Russell 2000 Small U.S. Stock 8.7% 38.8%
MSCI ACWI ex-USA* Foreign Stock 4.8% 15.3%
S&P Global REIT*  Real Estate Securities -1.0% 1.7%

 

 

In October of 2013, Eugene Fama, a professor at the University of Chicago Booth School of Business, was awarded the Nobel Prize in Economics.  Since Professor Fama’s work has had a strong influence on Dowling & Yahnke’s investment philosophy and approach to portfolio management, we thought we would expound on his academic accomplishments and contributions to the fields of economics and finance. Fama is most commonly associated with the “efficient market hypothesis,” which he first enunciated in 1970.  Market efficiency “is the degree to which stock prices reflect all available, relevant information.”  In a perfect “efficient market,” it is impossible for an investor to skillfully outperform the market because all available information is already factored into all stock prices (http://www.investopedia.com/terms/m/marketefficiency.asp).  New information, such as surprising earnings reports, product announcements, economic and political news, or mergers/acquisitions, is incorporated into stock prices almost instantaneously because investors react to this news by immediately buying or selling the stock, thus adjusting the price based on their aggregate expectations.  (It is important to note, however, that even in a truly efficient market, some investors will experience extraordinary runs of luck that will likely be interpreted as, and marketed as, skill.) Fama’s theory had massive threatening implications for the investment industry, which was premised on talented and hardworking professionals earning large fees by selecting the right stocks.  In the wake of Fama’s research, the first low-cost index funds emerged, which discarded active management and provided direct access to asset classes at much lower cost.  The migration to more passively-managed investment vehicles has accelerated in recent years as acceptance of Fama’s theory has become more widespread. We generally subscribe to Fama’s view on market efficiency.  However, because efficiency relies on transparency and free flow of information, different asset classes may have varying levels of efficiency.  As an example, consider a highly-followed large-cap stock (e.g., Apple), which is tracked tenaciously by dozens of highly-educated professional analysts and millions of individual investors.  Every press release, conference call, product announcement, or stock sale by a corporate officer will be parsed for any sign of meaning for the company’s share price.  Contrast this with a small manufacturing company in an emerging market such as Malaysia.  A far smaller audience is even aware that this company exists, and very few people are probably considering its shares for investment.  In addition, the country may have much less stringent regulatory reporting requirements, thereby impeding the free flow of information.  The share price of the Malaysian company will probably incorporate new information in a slower, lumpier fashion, increasing the odds that active management might still provide some value.

“Fama’s theory had massive threatening implications for the investment industry…”

Fama’s theory of market efficiency is often misinterpreted as implying that prices are always “right.” Critics have frequently cited the bubble in internet stocks in the late 1990s as evidence that markets are not efficient.  We disagree.  Even in such frothy conditions, stock prices in widely-followed markets still digest information very quickly.  Fama never said that the market, even in aggregate, would not occasionally make mistakes in processing information.  He said that in an efficient market, the conclusions the market draws from available information, however erroneous or misguided, would be reflected in security prices very quickly. Fama’s second major contribution to the field of finance was the early-1990s development, along with Professor Kenneth French, of the three-factor asset pricing model.  Fama and French demonstrated that historically, returns on small company stocks have exceeded those of large company stocks, and returns on value stocks have exceeded those of growth stocks.  The model they developed essentially states that the returns on stock portfolios can be largely explained by the degree to which the underlying stocks have “small” and “value” characteristics.  This discovery again proved to be a shot across the bow of some active managers, who had demonstrated success in outperforming a broad market index; the more probable explanation was that they did so simply because of the characteristics of the stocks (small value) in their portfolio. Eugene Fama’s groundbreaking discoveries in the field of asset pricing have had a major impact on best practices in investment management.  Market efficiency is now generally the default assumption; rather than the need for active management just being accepted, active managers now have to prove that the market in which they are investing has inefficiencies that can be exploited with their particular skills and expertise.  Thanks to the three-factor model, manager performance can be further dissected to determine whether the manager simply benefitted from the types of stocks he was buying, or whether he actually demonstrated real outperformance.  Fama’s research led to the founding and ongoing evolution of Dimensional Fund Advisors (DFA), a mutual fund firm with which we have partnered for over 20 years.

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