Ken French's new market theory

It's not often that a financial advisor gets to meet a true giant in any field. I recently had an opportunity to attend a lecture by one such giant in the investment industry. His name is Ken French. He's a finance professor at Dartmouth College's Tuck School of Business and a Director of Investment Strategy for Dimensional Fund Advisors. He is also the co-author of the three-factor model, which is now widely accepted as the most defensible and robust explanation of what drives risk and return.

His lecture showed compelling evidence that portfolio performance is primarily effected by three things: exposure to equities as compared to fixed income; exposure to value stocks as compared to growth stocks; and exposure to small companies as compared to large ones.

This view is based on the efficient market hypothesis (EMH) that prices are pretty much always close to being fair. To quote French: "No one says mispricings don't exist, it's just that so few people can economically exploit them." His view is that markets are "sufficiently efficient" it is unlikely any given active manager will make money trying to outguess others on any differences.

As such, he suggests that people may wish to replace the phrase "efficient markets" with the phrase "equilibrium markets," since markets may misprice things a little every now and again. However, he believes most people should act as if prices are right, since any mispricing is just as likely to err on the negative side as on the positive one, and is about equally likely to be of about the same order of magnitude. Surprisingly, French also disdains people who take an absolute view of market efficiency. While actual numbers are unknown, he says most experts believe markets are somewhere between 80% and 92% efficient.

French's simple view of the active management industry is that, on average, people are spending $2 (on research, analysis, company visits, etc.) in order to make $1. Obviously, his view is not very popular. He believes people would be far better off if they didn't worry about trying to "beat the markets" instead of focusing on the things they can control, such as cost, minimizing bid/ask spreads and portfolio turnover.

The work done by French and his research partner, Eugene Fama, shows that tilting toward small companies can increase a portfolio's expected return by 1.5% to 2.0% per year and that tilting toward value can increase the expected return by 3% to 3.5% per year. Of course, risk would also increase, but not on a one-to-one basis.

So why is it college students know all about this stuff, but financial advisors are generally oblivious to it all? Many believe most advisors reject the Fama/French research because it debunks their "value proposition." Financial advisors and mutual fund managers make money by charging fees for picking stocks.

People -- especially financial advisors -- need to understand that it is highly improbable any of them can add value by doing that. Still, French believes comprehensive, holistic advice usually adds value; but active management usually does not.