The current issue of the Financial Analysts Journal has an interview with finance-theory pioneer Eugene Fama in which he comments about money managers, the causes of the financial crisis and the portent of inflation.
Fama, a professor at the University of Chicago, is credited with much of the work on the modern theory of how the stock market works. Along with Kenneth French, a professor at Dartmouth, Fama developed comprehensive explanations for factors explaining the pricing and returns on stocks.
Fama can be brutally honest and concise. On the wisdom of hiring a human stock picker, he says: “An investor doesn’t have a prayer of picking a manager that can deliver true alpha.” Even over a 20-year period, he says, the noise surrounding a manager’s performance is so high that it’s “difficult, if not impossible, to distinguish luck from skill.”
After costs, only the top 3 percent of managers produce enough return to just cover their costs, which means that even top performers are likely to be only as good as a low-cost passive index fund. The other 97 percent can be expected to do worse.
So much for the thousands of highly paid investment managers and the advisers who assess their performance.
Fama also dismisses the financial crisis as having stemmed primarily from “political pressure to encourage the financing of subprime mortgages.” The recession then triggered those mortgages to fail, causing the broader crisis.
“I don’t think the crisis was a problem with markets. The big recession was the trigger. The worst thing to come out that experience, in my view, is the concept of `too big to fail.’ ”
The problem with too big to fail is that big banks can sell their debt as a riskless asset, making it easy for them to expand and become an even bigger problem. Business executives won’t “consciously tank their companies,” he says, but too big to fail pushes them to take on too much risk.
Dodd-Frank does little to discourage this, because the modest 25 percent capital requirement would not eliminate the moral hazard that leads a Citibank or Goldman exec to take on excessive risk with the comfort that government will bail them out. With a high enough capital ratio, he says, debt is truly riskless because the equity holders will burn through all their money before the debt is in trouble.
Fama also frets about public pensions, saying managers should assign the same discount rate to the cost of future benefits as Treasury Inflation-Protected Securities, currently yielding 0.17 percent, because the liabilities are the equivalent of inflation-adjusted notes. Instead, governments discount those future liabilities at 7 percent or 8 percent, a hoped-for but highly unlikely rate of return on their investments.
The crisis the country faces is eventually a big state is going to go bust because of its pensions. State constitutions typically provide that the state first has to service its debt, then make its pension payments, and then pay for services. What we don’t know is whether that order will be enforced.
Ultimately, the busted state is going to be looking to the federal government for a bailout. Think Greece on a bigger scale.
Finally, Fama offers some dismal thoughts on inflation. Starting in 2008 when it intervened after Lehman’s collapse, he says, the Federal Reserve has purchased $2.5 trillion in debt financed almost entirely by excess reserves at the banks. The monetary base was about $150 billion before the Fed began buying. The Fed has been paying interest on those reserves, theoretically to compensate banks for the “opportunity cost” of maintaining higher reserve balances at the Fed.
That’s simply “issuing bonds to buy bonds.”
Banks can turn those reserves into currency on demand, though, meaning the Fed has abandoned its most potent tool for controlling inflation, the monetary base of currency plus reserves. The ratio of the monetary base of some $150 billion to the $2.5 trillion in reserve-financed debt on the Fed’s books represents how much the price level could rise, he says.
“Economies typically do not function well in hyperinflation,” he says. “The real value of government debt might disappear, but the economy is likely to disappear with it.”
There is a way out: Balance the budget.
Mark Sievers, president of Epsilon Financial Group, is a certified financial planner with a master’s in business administration from UC Berkeley. Contact him at firstname.lastname@example.org.