In the ultimate irony Morgan Stanley, an icon of active investing, and the American Financial Association jointly awarded its prestigious Award for Excellence in Finance to Eugene Fama, finance professor at the renowned University of Chicago School of Economics. If they really understood what he wrote about, they would stop picking stocks, timing markets and selling actively managed mutual funds.

Eugene Fama has provided powerful information about how stock markets work. His important work began to take shape with his 1964 doctoral thesis, “The Behavior of Stock Market Prices”. In his thesis, Fama set forth an explanation of market efficiency and why it ensures that the current price is the most accurate price. Fama asserted that actual prices are the best estimates of a stock’s fair value because competition among investors causes share prices to move swiftly, absorbing all current information and future expectations. This Efficient Market Hypothesis makes it virtually impossible for an analyst to consistently locate and profit from price anomalies.

Fama further asserted that past price patterns have no bearing on the future direction of stock prices. This assertion, known as “The Random Walk Theory”, essentially eradicates the notion that stock pickers can pick future big winners based on past performance or information that has already been revealed about a company.

Fama’s thesis, as well as his subsequent work, has transformed the investment industry. In fact, Fama’s important work has led to a proliferation of index funds—answering the call for a low-cost way to capture market efficiency and the expected overall increase in stock market equities as a whole over time.

Fama’s stock market research further led him to question why some stocks perform better than others. He joined efforts with Kenneth French (currently a finance professor at Dartmouth), and the two reconsidered William Sharpe’s Single Factor Model which asserted that stock market returns are explained by their exposure to the market as a whole. Fama and French determined the Single Factor Model on its own did not go far enough to explain differences in stock market returns as it accounted for just 70% of returns. Fama and French set out to identify additional factors that would explain all, or at least the lion’s share of stock market returns.

In June 1992, Fama and French, published “Size and Book-to-Market Equity: Returns and Economic Fundamentals”, their ground-breaking research paper that significantly improved upon William Sharpe's single factor asset-pricing model. Fama and French’s research led them to identify that, in addition to the market itself, a portfolio’s specific sensitivity to size and value impacts returns.

The two revealed their Three-Factor Asset Pricing Model which provides isolated and specific risk and return characteristics for small and value companies.

The figure below reveals the risk (standard deviation) and return characteristics for the Three factor Model. The returns (above the orange bars) are the average annual returns for the three Fama/French Risk Factors for the last 80 years. At last, investors can invest with specific risks and expected returns without succumbing to guesswork, speculation and fear. 

Fama and French’s Three Factor Model serves as an invaluable tool for asset allocation and portfolio analysis. The Three Factor Model has revolutionized how portfolios are constructed and analyzed. From their findings, Fama and French soon introduced the first concentrated, empirical value strategies. Their research led to similar findings internationally, and they updated their studies in 1998 to include data from as far back as 1929. Fama and French’s ground-breaking discoveries and research indexes are the cornerstone for IFA’s globally diversified and risk-optimized investing approach.

IFA is thrilled that Eugene Fama continues to receive accolades for his research that so heavily influences portfolio construction. It is particularly encouraging, albeit ironic, that this prestigious award and acknowledgement comes from a brokerage house that thrives on active management.