Welcome to The Bull, your personal finance podcast. A special occasion deserves a special place, and indeed, today we have reserved an entirely unique space for this extraordinary episode, outside the regular schedule of this podcast.

After 163 episodes discussing finance in every possible way and gathering an incredible and passionate audience around this podcast, nothing could better crown the journey we have had so far than speak it with one of the greatest living legends in the global financial landscape.

In 1970, a brilliant professor from the University of Chicago published a paper titled Efficient Capital Markets, a Review of Theory and Empirical Work, introducing for the first time the concept of the Efficient Market Hypothesis. Since then, the idea that the prices of securities already incorporate all available information, making it quite too impossible to systematically gain a competitive advantage based on publicly available data, has become the dominant paradigm in finance.

If today we talked so much about passive investment and ETFs, it is largely because that paper was written, and its author laid a cornerstone in our understanding of the fundamental mechanism underpinning market behavior.

Since then, many other theories have emerged, and other important models have explained aspects of securities pricing that the Efficient Market Hypothesis couldn’t fully justify. Yet, over 50 years later, the Efficient Market Hypothesis remains an invaluable model on which to base our own investment decisions. The author of that paper is a titan in the pantheon of great academics who have observed markets with extraordinary depth and seen what no one else could perceive.

We are talking about Eugene Fama, who, for his indispensable contributions to the understanding of finance, was awarded the Nobel Prize in Economics in 1993. It is with immense emotion and a lingering sense of disbelief that I’m thrilled to present my brief conversation with Eugene Fama, who just a few weeks in advance has given me and this podcast the most wonderful Christmas gift I could have hoped for. Enjoy the episode!

Riccardo: Dear Professor Fama, welcome to my podcast, The Bull.

Eugene Fama: Thank you.

Riccardo: It’s an incredible honor to have you here. Thanks for accepting my invitation.

Eugene Fama: My pleasure.

Riccardo: I would start with a very fundamental question. I’m afraid that you will be tired of talking about it, but, I can’t help but ask you about the concept of market efficiency. The concept of market efficiency is central to your work, and shaped modern financial theory. Could you explain what market efficiency means and why it matters when it comes to investing our own money?

Eugene Fama: Okay, so market efficiency says, in its extreme form, prices reflect all available information. So basically everything that’s knowable now is already in the price. Um, there’s no way to use information available now to make better predictions that are already in the price. So that’s, that’s the simple statement of the, of the proposition. Um, it’s a little more complicated to go about testing it because you have to say what the market’s trying to do in setting prices. But the simple statement I gave you is, is, is enough. So basically it means, you know, In terms for an investor, you’re not going to be able to beat the market. I mean, you basically have to say, I think the prices are right. So you, you decide how much risk you’re going to take, but you don’t, you don’t try to predict what the level of return is going to be, what the level of, uh, performance of any particular stock or asset is going to be.

Riccardo: You came up with this idea in the sixties, didn’t you?

Eugene Fama: I didn’t invent it. I invented the word market efficiency, but people had already been working on the concept for at least 10 years before that they hadn’t verbalized it very well. They put together a semi complete, a complete story about what they were trying to say, but basically they were struggling to come up with a framework, basically said, how would prices behave if all information that was available was already in the price? So there was a lot of work on that in the early 60s, late 50s. And I came along in 1963. So it was already going at that point. It’s a long time ago, but you gotta stand, it’s before you were born.

Riccardo: Yeah. I must admit I was born in the 80s actually. In your, original 1970 paper Efficient Capital Markets: A Review of Theory and Empirical Work you described three kind of market efficiency, the weak form, the semi strong, the strong form. Has your view about it changed over time?

Eugene Fama: I don’t know. I don’t, I don’t think those, those definitions were convenient for the time, but basically I think there, there were ways of separating the empirical research into different columns. Um, but other than that, they were not particularly important.

Riccardo: Okay. From your point of view are markets today as efficient as they used to be in the past? There’s a lot of debate about it, about the idea that markets used to be efficient and now they’re not any longer. Do you think that something has changed in the last 2 to 3 decades?

Eugene Fama: If it has, it’s not obvious in the prices. So what you’re saying is what people say almost all the time. It’s not new. I mean, it’s been saying it forever. They used to be efficient, but it’s not efficient anymore. Okay, show me the evidence. That’s what I want to show me. That’s what impresses me, is evidence, not claims.

Riccardo: If prices were obviously wrong, you should be rich.

Eugene Fama: Well, you should be rich. If you can identify in what way they’re wrong, right? They are wrong. They’re always wrong because they change after the fact, right? The new information always comes along that, that changes them. Uh, but it’s basically unpredictable for most people. Well, not, not everybody. Some people are able to beat the prices and they’re like corporate insiders. People have access to special information or people who are really good at evaluating the information that’s there. Of course, it’s not the typical investor. It’s not the typical investor at all. The typical investor basically should behave as if prices are right.

Riccardo: So you are basically saying: for an outsized majority of the investors it is impossible to purposely exploit market inefficiencies in a repeatable way, even if they might exist to some extent.

Eugene Fama: Right.

Riccardo: And why do you see so much effort from hedge funds, asset managers or individual stock pickers deployed to try to beat the market? We all know that is very unlikely that one can consistently beat the market, but there is a huge industry trying to do it or at least tring to sell the idea.

Eugene Fama: Right. Um, there, remember, it’s all about fees, right? So if I can make money doing that, I’ll do, I’ll do it. But there are, there is, there, that is an important activity in the sense that something has to, something has to get the information into the prices. So that’s basically done by these informed investors, but how much they get from that is, uh, if you look at the empirical evidence, it says, yeah, there’s evidence that there are people that can beat the market to some extent. And there is, there’s evidence that people actually lose when they try to do it. Active investing is interesting because the winners eat the loses, which is what it basically comes down to. Um, but you know, it’s, it’s very marginal, but that’s, that’s probably all it takes to make the market efficient. But if, if you’re not, uh, particularly well endowed to play that game, you should basically stay away from it.

Riccardo: Is it possible to know in advance if I am endowed enough to play that game? From the very first time I read it, I was impressed by your 2009 paper about luck versus skill. It’s very difficult to say if I’ll ever be able to beat the market, although I’m skilled to do it. How can I know what game to play?

Eugene Fama: Well, so that’s an excellent question. I’m working on it right now with Ken French. So what we’re trying to do is to show you the extent to which the information that’s embedded in a, uh, a good active investors decisions is buried in lots of uncertainty after the fact, because things change in the amount of noise in the amount of unexpected variation in the data relative to the information. It’s very high. So basically after the fact, you can, if you look at it hard, you can see the, uh, the tracks of skill in there for some investors, um, but it’s very, you know, a lot of uncertainty. Uh, so when you play that game, you’re basically accepting that maybe you’ll do a little better, but maybe you’ll also be subject to a lot of uncertainty if you’re going to play that game, you have to do it in an undiversified way because. You’re not going to have good information about everything out there. That’s not, that’s not possible. So you get to basically play an undiversified game and that’s a, that’s kind of a killer because you took a lot of, a lot of variants that you don’t take if you just buy the market as a whole, a lot of variability in returns that you did, you have to accept it rather than just buying the market.

Riccardo: Very Interesting. If you don’t mind, let’s shift to talk about another one among your groundbreaking discoveries, the factor premiums. Since 2009 in the years of zero interest rate policy, we’ve seen, Growth stocks consistently outperform value stocks and large caps outperform small caps. Do you think this might represent a fundamental shift in market dynamics, driven by, I don’t know, mega tech companies or extraordinary macroeconomic policies or whatever else, uh, or are the traditional factors, let’s say, still valid.

Eugene Fama: It’s a great question. Um, cause what happened after we did all of that early work is that People piled in on it. So they started investing in the so called value stocks because they had in the past higher returns than, than, than growth stocks. But the problem is if lots of people do that and they’re only doing it to, because they think they’re higher returns, they can kill it. You can have excess demand for those stocks and you can wipe out that value effect. Now we don’t know, but ever since it was discovered, it hasn’t really been there in the data. In some markets it has, but in most markets it hasn’t.

Riccardo: I got it. It’s a very relevant question today because we are investing in a market with, 10 companies which account for 30 to 40% of the S&P 500 total capitalization. It’s hard to make decision today because growth stocks are the clear winner of the last decade but on the other side we have all been taught that value stocks in the long run should be outperforming growths stocks.

Eugene Fama: Maybe, maybe, maybe not. You know. We really don’t know. Okay. That’s true. So it, when I say you don’t know, you don’t know. In other words, the end, whoops. Okay. Can you see? Okay, so sorry, I’ve lost you for for a moment. You’re ready for a couple of seconds. I got it. I got So you really don’t, you really don’t know because the amount of volatility in prices is so high that you can’t tell whether things have changed or, or not. It takes a long, long time, an investment lifetime to identify whether there’s been a shift away from value, having higher returns, for example.

Riccardo: Okay. Of course we don’t give any financial recommendation, but if I can wrap up your thought you wouldn’t advise to invest thinking in terms of value beating growth or small beating large.

Eugene Fama: I don’t think any retail investors should do that. I think they should just buy the market. Okay. It’s always been, you mentioned before we lost that picture there that. A few stocks have done, are a big share of the, of the total index now, but that’s always been true. It’s just that they change through time, but if you buy the index, you’ll get them. So you’ll get, you’ll get the, you’ll get the ones that are currently big and you get the ones that will be big. If you buy, if you buy everything and you’ll get the ones that will be small too, the ones that shrink. I mean, that’s the game, right? This is the general stock. So sometimes you win and sometimes you lose.

Riccardo: That really makes sense. The psychological problem is that if you read the media, it always looks like: it’s a weird Market. Things have never been so in the past. Valuation are clearly unbearable. We are at the peak of a bubble. For at least 18 months most of the media have been delivering the idea that there’s something’s fundamentally wrong with what’s going on in the US stock Market. Let’s be clear, I totally buy what you recommend for retail investor. But when I read the Wall Street Journal every day I read articles telling stuff like: oh, the market is too concentrated, somehow there’s going to be a reversion of the mean anytime soon, let’s move to bonds an so on and so fort.

Eugene Fama: That’s, that’s entertainment, basically. Entertainment.

Riccardo: Ahahah so the advice is: Just don’t read the newspapers.

Eugene Fama: Entertainment is a business. There isn’t that much news. So entertainment is a business.

Riccardo: Okay. Let’s come back to the risk premium. In the 90’ you and Ken French came up with the three-factor model, then extended to five-factor model. With that model you managed to you explain most of the excess return in the stock market, what the CAPM couldn’t do by only resorting to beta, the market risk factor. In a nutshell the idea is: excess return comes from taking systematic risks when tilting the portfolio toward value stock, small caps stock etc. But another well known factor is momentum, which seems to behave somewhat differently from the other factors embedding a systematic risk premium. What’s your opinion about momentum as an investing factor?

Eugene Fama: It’s not attractive because if you look at momentum, the turnover among momentum and momentum stocks is incredible. So you’re talking about a very short term phenomenon with lots of variation, who’s in there now and who isn’t, um, who’s high momentum and who’s low momentum. So if you were going to implement that strategy, it would be very expensive in terms of trading costs because, because there’s such turnover. So I don’t know of any evidence that anybody has ever exploited momentum in a, in a, uh, you know, a way to make a lot of money and people are trying, but there’s no evidence that they’ve succeeded very much. There’s some people that have made money on momentum, but when you look at them, you say, I don’t think they did that consciously. I think they just happened to invest in the high end momentum stocks. Because in hindsight, because they aren’t doing it a year later, you know? Okay.

Riccardo: I understand. Do you think the factor ETFs can be a mean to try to exploit momentum premium at a lower cost?

Eugene Fama: Uh, no, there’s no way to exploit momentum at low cost. There’s no way to do it. So whoever is managing those portfolios, it’s going to be the cost. And then the. You know, the, uh, the, the, the fund holders pay the cost indirectly. This comes right out of their asset value. Costs get born by the investors, no matter what.

Riccardo: Clear. Some critics of the efficient markets hypothesis talk about bubbles, irrationality and other stuff that somehow have to do with biases in our rationality and to some extent the efficient market hypothesis was bound to an idea of investor behaving rationally, or at least this is how the efficient market hypothesis is generally taught. So the question is. If our rationality is biased and that affects the way we invest, as people like Robert Shiller or Richard Taylor say, do you see contradictions with the efficient market hypothesis or is it consistent with idea that we make investment decisions, which are somehow distorted by our own biases?

Eugene Fama: Sure, so, uh, they basically believe that there are patterns in stock prices that are more than random. So the bubbles are an example. A bubble is something that breaks predictably. If it doesn’t, it’s not a bubble. Uh, it’s just variation in the price. So when I talked to Shiller, basically what he says is he believes there are bubbles, but he can’t document it. Um, but that’s, that’s what all that impresses me is document it and I’ll believe it.

Riccardo: Okay.

Eugene Fama: I don’t see, I don’t see any evidence. For example, um, Shiller predicted way back. I forget when it was in the, uh, the head of the fed at that time. Okay. Went along with it and broadcast what he said that stock prices were too high. They were at historic highs and they did indeed fall. The problem is within two years, they were way past the previous peak, uh, which was the bubble, you know, the, the up and the down or the down and the up. So it’s very, very difficult to, to make sense of that stuff. But if you, if you can, I wanna see the what, how the, the evidence that you compile to convince me that there are bubbles in the market. So, so far it hasn’t happened.

Riccardo: Yes. It becomes evident, only after the fact.

Eugene Fama: Yeah. Right.

Riccardo: Recently in my podcast I talked about a bunch of recent papers, authored by a team led by Robert Bordalo from Harvard, that have challenged the risk premium idea and claimed the factor premiums could be explained by systematic errors in forecasting. Their idea is that the portfolio’s short legs systematically disappoint market expectations, therefore factors would be proxies for non-rational beliefs about future growth. What do you think about that.

Eugene Fama: And why do you use that to, well, actually, um, there have been people who’ve been saying that all along, that people overreact to both good news and bad news. So the value stocks would do well because people overreact, react to short term fast bad news about these companies. And in the opposite for growth stocks, they do poorly eventually because people overreact to their good times. Um, but I don’t know that I don’t see any evidence of people, you know, supporting that empirically.

Riccardo: Okay. So it could be, but it can’t be consistently exploitable.

Eugene Fama: It can’t be. I don’t say it can’t because then that assumes I have the evidence, you know, but I don’t have the evidence. People make claims not supported by the evidence. I try not to do that. Um, uh,

Riccardo: Nowadays there’s a lot of discussion about ESG and ESG investment. Do you consider ESG an investing factor or do you have any opinion about it?

Eugene Fama: Yeah, it’s a lot of, um, wasted breath. I mean, so there’s a backlash against it now. Yeah. Um, people are rebelling against the whole notion of, uh, you know, treating some people better than other people because they’re in the right hoops. But that’s just not, not the right thing to do in a democratic society. Um, so right now we’re going through a big kind of a rebellion against that. In the US and universities particularly are getting pushed to move away from that people. Their donors are saying, “Why in the world are you doing that kind of stuff with my money?”

Riccardo: Yeah I’ve read about it. Let’s talk about a topic I really care about, passive investing. You are one of the Big heroes of this revolution along with, Harry Markovitz ,William Sharpe and few other great minded people. Recently ETFs asset under management have outgrown those of active mutual funds, at least in the U S, in Europe not yet. With the rapid growth of index fund and ETFs, do you see threats for the market efficiency? You know, there are a lot of hedge fund managers, for example, talking about this threat all the time. Is there a point where passive becomes too much passive in the market?

Eugene Fama: It’s possible, but I don’t see any evidence to that effect yet. It’s possible that if everybody drops out and nobody tries to use information to, to, uh, predict prices, then the prices won’t be efficient anymore. So you can’t have a hundred percent passive investing.

Riccardo: Of course,

Eugene Fama: there has to be some smart, active people that are in there using information to help set prices. Um, so the reality is for most people, that’s a, that’s a, that doesn’t yield anything in the way of returns, but for, for some it does, with a lot of uncertainty around it though, that’s, that’s the, that’s the problem, that the actual returns are much more variable than what’s predictable about returns. So you, the, the trick is to separate what’s predictable from what’s unpredictable. We’re working on that right now, actually. Just to show people how much unpredictability there is even when underlying in the returns on Stocks, there is a predictable component.

Riccardo: Why do you think there seems to be so much concern about it? Ok. I I’ve heard about some hedge fund managers very angry beacuse their investment didn’t play out well. And they said, ah, the problem are index fund and ETFs causing distortion in valuations and my strategy not to work. And so they say, that’s the problem. In your opinion is there some reason of concern going on, I don’t know 10 years from now, when maybe ETFs and index funds will be 60, 70, 80 percent of the market?

Eugene Fama: Oh, I don’t, I don’t know what the right number is. It depends on how much, how much, um, how much knowledgeable investment do you need in order to make market efficient, make markets efficient. I don’t know the answer to that because it depends on how many bad investors are in the market. So basically the, the good ones, the good ones have to eat the bad ones. If they kill the effects of the bad ones on the prices. So if the bad ones drop out, you don’t need as many good ones in order to make the prices right. But nobody knows what the right numbers are in the markets that we That we that we deal with, you know,

Riccardo: A couples of days ago I’ve listened to Clifford Asness in a podcast and he reported that John Bogle was credited to have said 75% is the threshold. When he asked Bogle: How did you come up with that number, Bogle said: I made it up

Eugene Fama: Great Who was it? I know Cliff, but who was the other guy? Cliff, Cliff. I know Cliff. He was at the Compound and Friends with the guys from Ritholtz. The hosts were Josh Brown and Michal Batnick. Cliff was my research assistant a long time ago.

Riccardo: I know. He talked a lot about it in the show. To someone willing to start investing, would you suggest otherwise than simply buy an old a market cap weighted, globally diversified portfolio? Of course we are in Italy and although we always look at the S&P 500, we know it’s not the same investing from here as if we were in the United States, but holding a market cap weighted portfolio, is definitely the most reasonable thing to do?

Eugene Fama: Yeah. I’m not a big S&P 500 fan because it’s only 500 and the list changes. From time to time, so yeah. Okay. I like the total market portfolio better, where you buy everything basically. Maybe not the very smallest stocks, but way below the first five, way below the 500. And you don’t try to pick the 500, you just pick ‘em on, just put ‘em in on the basis of market value. But you go way, you don’t, 500 is, I think you gotta go way past that, man. A thousand, 2000, who knows? But there are total market portfolios out there now, so. Those are the ones I like.

Riccardo: even outside the U S?

Eugene Fama: well outside the U S. I don’t know if they’re a total market portfolio. I don’t know. So we should know from our perspective.

Riccardo: Yes, but they’re all large cap stocks. Globally diversified, but mostly large caps. Ok. So what’s the, uh, what’s the Italian version of the, of the market portfolio? Is it, I mean, training? Typically those who use ETFs invest in the MSCI or FTSE indexes or stuff like that. Some 2000-3000 companies, but mostly large caps with a 60 to 70% concentration in the United States. There’s a lot of debate here. Is it okay to invest that much in the U. S. and not being really globally diversified?

Eugene Fama: Well, I think it’s natural for people to have a bias towards their own legal area. So I don’t know, for Italy it might be the EU. Not, not Italy, but EU. Stretching it to the U S says, well, there’s never going to be a time when the U S and the EU are at odds and somehow investors get expropriated. The problem is that’s happened in the past many times and investors get expropriated and they never get, they never, they never get, you know, they never get their money back, even if this side wins. The expropriation sticks. Nobody, nobody cares about investors, basically. So, international investing has this, this big risk, well, at least in the past, this big risk associated with it, that people aren’t aware of, because it’s not in the data. The data only cover periods when the markets were open, and there was free trading among cross markets. Uh, but that’s not, that’s not been an entire historical experience. We have had wars.

Riccardo: In the developed world I think we can trust each other and be confident that the market will still be an open one in the predictable future. When it comes to emerging markets, eeehhh, it could be something to be considered.

Eugene Fama: Right. Right. Well, you know, will the, will the EU hold up forever? Will it always be the EU?

Riccardo: Yeah. Good question.

Eugene Fama: 1940s and 1945 was. Kind of an eye opener, more than an eye opener, it was an opener for everything. So, investors outside of Germany got expropriated, uh, by the Germans and, and markets outside of Germany expropriated the Germans. So, that’s going to happen every time you get into a bad situation. Maybe it won’t happen in the future among those countries, but that says the EU will hold up. I hope it does. I hope it does.

Riccardo: We hope so too.

Eugene Fama: Yeah, .

Riccardo: What is your view about the current situation? We are in a threshold moment, shifting from the world order resulting from what happened after World War ii and the following dominance of the US. Now we’re talking about de globalization, de dollarization, new world orders, new players, China, India, and all this stuff.

Eugene Fama: Yeah, it’s always changing, it’s always changing. So China of course is the big, is the big uh, question mark now. And the big question mark within China is, they’re kind of reverting to their old scheme of things where the Communist Party kind of, you know, stepped down on everything and tried to control everything. And that, that’s not the way they got to be successful, uh, from, in the, in the post war period. They got to be successful from, from real capitalism. Yeah. But if they, if they start moving away from that, we don’t know what will result. Directed economies have not historically done well. That’s, uh, that’s, that’s the, that’s the reality. So, so we’ll see. There’s, there’s a lot of turmoil in the world at the, at the moment. And China historically has needed trading, well historically I mean the past 50 years, has needed to trade with the rest of the world. In order to advance itself, of course, but they, they may think that they got rich enough now that they don’t really have to lean on that anymore. There’s enough internal consumption to keep them going and growing. I don’t know if that’s, we’ll see if that’s true or not.

Riccardo: And what do you think about tariffs?

Eugene Fama: Tariffs, tariffs are self defeating because One country puts up tariffs, the other country hits them with tariffs coming back. So they’re always self defeating, it just doesn’t work. It’s politically, it’s politically

Riccardo: I assume It’s going to be a big topic in the near future.

Eugene Fama: It’s good. It’s politically attractive, but it’s not economically attractive. Economists don’t like tariffs, basically.

Riccardo: Um, professor Fama, thank you so much for all the time we spent together. It was a great pleasure to have you here.

Eugene Fama: Okay. My pleasure, actually. Thank you. Bye. Bye. Bye. Bye.

And that’s all, folks! I hope you enjoyed the episode and that the interviewer didn’t seem too dumb compared to the immense greatness of his guest.

But even if that were the case, well, anything Gene Fama shared with us is infinitely more valuable than the smartest thing I could ever conceive. I don’t know if Professor Fama will ever listen to this episode, although he asked me to tell him when it will be published. If he will, dear Professor Fama, thank you from the bottom of my heart for gifting us this moment and for enriching this podcast with your participation.

As always, I invite all of you listening to follow and turn on notifications on Spotify, Apple Podcasts or wherever you are tuning in and to leave a five-star review to support us and help us creating new content. That’s truly all for this extraordinary episode, and I’ll catch you again tomorrow with a new chapter of our journey through the world of finance. Always here, of course, with The Bull, your personal finance podcast.