Founder, Managing Director and CEO of Kotak Mahindra Bank, Uday Kotak, caught up with the winner of the 2013 Nobel Prize in Economic Sciences, Prof Eugene F Fama, at the NSE’s Dr. RH Patil Memorial Dialogue 2020, and spoke about a plethora of topics such as bubbles, technology and Indian markets.
While introducing, Kotak said India has extremely efficient equity markets. Indian equity markets have much greater liquidity than many other aspects of the financial markets, he added.
Edited excerpts from the interview:
Uday Kotak: Would you want to share how you got fascinated by the computer and the power of computing? I think it was sometime in the ’60s.
Eugene Fama: It was the early sixties, 1962. And there was just a computer on campus and nobody was using it except me and a Professor in the Physics department. We had to basically figure it out of the existing one and I used to call IBM and tell them there was something wrong with the computer and they would laugh at me. And then after I called him about three or four times, and I was ready to be dammed, they didn't laugh at me anymore.
UK: In those days you were a student, Professor, is that correct when you were using the computer for the first time?
EF: Right, that was my second and third year in Chicago.
UK: Yeah, but that highlighted your fascination for Mathematics in the business of markets. If I can then ask, of course, you then went into the building of the whole Efficient Markets theory, and I understand your neighbour at Chicago across your office is another Nobel Laureate who focuses on Behavioural Science and Markets. As a person who is gone and built the whole efficient markets model and the philosophy, how do you respond to Behavioural Finance? And maybe you want to share something about your neighbour as well in that context, because both of you are from Chicago and completely different perspectives and neighbours.
EF: Right. Well I tease him all the time and say Behavioural finance is really a branch of efficient markets, because all it is as far as I can tell is a critique of efficient markets and not lot of efficient markets are your critics. So, I always say I'm the most important person in Behavioural finance because without me they have nobody to pick on.
UK: But professor, why would you believe that, and which is the core of your conviction and you have also said that both of you rely on the same facts but have different interpretations between your Efficient markets theory and Behavioural finance. Why do you say that, based on the research of the model versus behavioural finance for markets?
EF: I’ll give example. So, there is lots of evidence that professional managers don't beat the market and he agrees with that evidence, but from his perspective what it means is that like everybody else, professional managers are just dumb. But from my perspective it just makes prices adjust to information. We take the same facts and interpret them differently. That's kind of what happens between us quite a bit. We typically agree on facts and disagree on the interpretation.
UK: Professor, if I take an extension of that does it mean that you believe discretionary portfolio management is not a smart way for investors to be putting money? They should rather be putting money in Index funds because markets are efficient and therefore they will give a better outcome than discretionary fund managers.
EF: A better outcome and a cheaper outcome because yeah, the discretionary of the active people judge way more than the passive people to take in money. So it's not only better it's also cheaper, but we need some informed active investors to keep the market efficient. So I agree to that entirely. The problem is most of the professional managers just don't seem to be particularly informed.
UK: In fact on discretionary fund management, you've used the Zero sum theory. Therefore, if somebody is more weighted in particular stocks versus the index somebody else's less weighted, therefore somebody’s made more money somebody's lost more money than before market is better off. So a little bit on that Professor.
EF: Oh that's not a theory, that’s a written and probably one of them is a loser. So, I think that’s not a fact. So I think at the moment the markets seem to betting that they won't get the senate because if they do I would think he's going to do that, but we'll see it, I don't make predictions about markets.
UK: Okay. But the core of your theory is prices at any point of time fully reflect all available information. That's the core of your theory, right Professor?
EF: Exactly.
UK: Okay. So, in that context I wanted to talk about a person who was your student, a gentleman called David Booth. Now of course, he has his name as the Booth school at Chicago, and he was a big follower of your theory and then he went out to set up a separate fund management outfit of his own called Dimensional fund management, run by David Booth, where you have been very closely involved. In the initial stages, he was focused much more on small cap and mid cap stocks, as I understand that. Two questions, what made him successful and how effective is the efficient market theory for small and mid cap stocks, professor?
EF: Well, I think it's pretty efficient. So, the idea is that small stocks and value stocks so-called value stocks, if there are risks that they are subject to the stats and subject to that gives them a different dimension of expected returns. They started out with small stocks, but then basically moved into value stocks of outside groups and around the world. They're much too big to just be smashed back to just one.
UK: Okay. If you look at the Indian markets and if you look at the National Stock Exchange, they have an index which is known as the NIFTY, which is the equivalent of say an S&P or the Dow, whatever is comparable you may want in the US context and today the most widely traded stock in India is the NIFTY which is the index of 50 stocks. NIFTY 50 as it is called and the amount of volume which happens around that is a justification of your theory of efficient markets. However, if you looked at the amount of money in India, which is currently under discretionary portfolio managers versus index even now most Indian investors are putting money in discretionary portfolios.
EF: Just to go from zero to 20 percent passive. Now it's up to 50 plus years have gone by. Now it's up to 50 percent passive pretty much the same as in India. Yes. I think you can go a lot higher. Won't do much harm to the market, we'll see where it goes. Basically all investors like to think that they can pick a person who will do better, but the evidence says really they can't.
UK: But Professor at the point which you alluded to, if everybody goes passive, what happens to the stocks outside the index?
EF: Well, passive might includes everything, not just the NIFTY50. It's a big total market index and not just the NIFTY 50. It's those kinds of things are self correcting. If it happens that not enough people are interested in the remaining stocks, they ask people to move over there and there'll be passed. People come along and staff smaller stock funds. I would think that eventually.
UK: In your theory which was you know, and which you have done for many years. The progress of technology and increase in the rate of information dissemination in today’s markets, is that making it even more efficient or do you think that is a lot of noise?
EF: There are two pillars of asset pricing; one is efficient markets that is just information. The other is risk and return is where asset pricing models. How do you measure risk? What is the relation between expected return and risk? So the question about small stocks and value stocks is not really about efficient markets. It is really about risk and return at least we have these real dimensions of risk which you get compensated in the expected returns.
UK: That is interesting. Therefore if you had to…if an investor had to put money especially in the COVID environment with all that information which is available, should he go for growth or value?
EF: I think he should go with the market.
Uday Kotak: He should go with the market, okay.
Prof. Eugene: Yeah. I think you have to start with the market as your core investment and then if you want to get a little more risky you might move towards. But generally I don’t think that just as you are really into all of this stuff you don’t know risk and return you should just probably stick with the market.
UK: Do you think COVID changes anything in terms of your theory? With the shock you got in March, the world market versus bounce back, Because this was an event of once in a hundred years.
EF: In 1918 yeah. So I don’t know what happened to markets then at that time. This one was kind of interesting. There was a drop in the so far that is a long term phenomenon. We will see the risk associated with. But it has never looked the same when we get done. I don’t want to be in the airline business because then I think you can see the businesses are figuring out that they don’t have to travel as much as they were travelling.
You see three days, two days of travelling and then go for a twenty meeting somewhere, this just doesn’t make sense. Now we have this teams in Zoom to talk as we are right now thousands of mile away quite nicely. We don’t have to get on a plane so I am not sure I want to be in the airline business.
Uday Kotak: Absolutely! Geography is history.
Prof. Eugene: Yeah, I like that one.
UK: And therefore Professor how would the world change the economy is more a general question, how would you think the financial markets change in the post COVID world if you had to just…?
EF: Yeah, change in what sense though?
UK: I mean, do you see some fundamental structural changes in the behaviour of markets?
EF: No, I don’t see any reason to think that. It could happen I mean, this markets are always changing to some extent. So this is a big event but no, basically finance is one of the industries that kept going right through out. It just really didn’t stop or slow down even. So this I think really what they have been doing based on the COVID experience.
UK: Moving onto another favorite subject in the minds of the investors globally which is ESG.
EF: Yeah.
UK: Do you think that changes the investor behavior and preferences in favor of sustainable technologies and how do you also in that context look at this concentration of investments in a few stocks and some people of course consider it to be potential bubbles, and I know you have a view on bubbles. So how do you look at this change which is happening? One is the whole theme around ESG which is one question, and the second is, do you believe that few stocks we are seeing huge concentration and reflex in potential bubble?
EF: About ESG at the moment. I don’t think the investors understand that if they turn their investment towards particular kinds of stocks, they think they are on environmentally friendly, socially friendly or whatever. If you turn towards those stocks what you are going to do is push up and lower their expected returns. So what I say is your choice has its own reward and expect that you are going to get higher returns from doing that because the logic of what is the can actually be the lowest.
Basically, So that one I know I think that is something that people don’t understand very well. Now the issue is really that people are willing to pay more for products that are produced in an environmentally friendly way. If they are, then that could be a profit maximizing to take. Are they willing to pay we are talking about their willingness to pay more for the stocks in an environmentally friendly, one thing people.
The other big issue is that how do value in a world where they have ESG goals as profitability goals. So you can predict that they are going to say the profitability is lousy than ESG so. I don’t know how those decisions would be. Hope, is that the two are consistent that eventually the people want ESG products no push in that direction. We’ll see and I don’t think regulators especially in Europe I don’t think the regulators are thinking about this very well either.
UK: Therefore your belief is that the fundamental dichotomy between investors’ expectations of returns versus objectives of ESG are need to be better thought through the future.
EF: Absolutely.
UK: And then Professor your view about bubbles. People saying that there is a bubble in some of the tech stocks and some categories of the stocks as we talk. Your view on that at this point of time?
EF: Not just at this point in time, but at all points in time. It is basically, well bubbles are things people see as the 2020 they don’t see them coming they just see them going. Which means they have really bubbles because something that predictably breaks. Anywhere, they can predict when the bubbles break and that right there probably not bubbles they are just up identifying the peaks and drop and put data in them. When they got done he said, do you know what that really is, that’s a series of cumulated random numbers, that’s totally random. How do you top that one 100 years later?
UK: Right. Professor, one question on time varying risk. How good is time varying beta in forecasting asset prices in comparison to constant beta?
EF: So time varying beta is… we got to work on that. But identifying the time variation and the beta is difficult because of the volatility of the circumstances. They surely vary, there’s no doubt about that. The problem is, there’s not much evidence that beta is much related to averaging terms, that’s the fundamental. The original capital asset pricing model has never done very well in the data. There doesn’t seem to be much of a relation between beta and average returns. So, whether or not it could be measured time varying betas or not, are issues. They don’t tell you anything about expected returns.
UK: Professor, moving into another aspect of financial markets, which is the fixed income markets. And, of course, within the fixed income markets there are pockets which are liquid and pockets which are less liquid. How effectively does the efficient markets really work for the fixed income markets?
EF: Well, in the areas where we have pretty good data, which is basically government bonds, because those trade a lot, that looks pretty good. It’s a much easier problem than… valuing your bond is a much easier problem than valuing your stock, because the cash flow is predictable at least for government bonds… the cash flow is predictable. And so you’re really just talking about what’s happening to interest rates. It’s a much easier problem than you’re faced with stocks, where the cash flows are also fairly uncertain. So I think the bond market’s business is really good. We don’t have much interest in the bond market because as you say, the interest in the end would be the corporate end and that end is pretty, you don’t get just a lot of good prices there.
UK: I see. So the corporate end of the bond markets is more difficult to fit into the broad thesis when you’re building because of lack of information or liquidity or what is it?
EF: The reason of lack of information is because of lack of liquidity. Most corporate bonds just don’t trade; people buy them and hold them.
UK: Okay. Based on the ongoing research on markets and finance, what are some of the path breaking concepts, ideas you see which could alter the financial markets into the future? We want to have your mind peek into the future for us.
EF: Well (laughs) I’ve never been able to do that. People always ask me where we would be 5 years from now, I just never know because the world changes, my interests change and stuff evolves very slowly. So, I just can’t have an answer to that question. I know, if look back to when I started, there were basically 10 people in the whole world who were concerned about doing academic research in finance. And now there are literally thousands of people everywhere doing academic research in finance. So it’s very difficult to say where we’ll be in a couple of years, than by 5-10 years.
UK: And now moving a little bit to emerging markets including India, what are some of the critical aspects from a policy and regulatory standpoint that are crucial for evolution of financial markets and emerging markets like India?
EF: I think, having good available information is important. Our information gets out into the public. And even though the public in a way doesn’t have an advantage, insiders is important. So I think you have to insider trading and things like that and the information process and the market process. But, emerging markets tend to be pretty good on actual trading mechanisms that they have, because they are emerging, they’re able to adopt more modern techniques of trading pretty quickly, or even initially when they first We’re not worried about that part, we’re more worried about the information part. So, volatility in emerging markets is really high.
UK: Right. Professor, in many aspects of the human development, the machine has got the better of human beings. If you look at the game of chess, the machine now beats the human hands down. Again, if I asked you to peek into the future with the amount of computing power and AI and analytics which is going on, and predictability which will come into the models, would you think in the future, machines will beat humans in terms of returns from markets?
EF: I’ve been getting this question for at least 40 years now. So, there was a period back in the 70s when people were physically having a tough time getting jobs working in the stock market would be easy for them because they were so good with data. And it didn’t work out, it just didn’t work out. They used to come up with these artificial intelligence mode. While that’s making a big comeback now, but we’ll see where it ends up. See, I just don’t think the patterns that artificial intelligence would uncover, are actually there. I think that’s the basic problem. The markets are efficient. They adjust in ways that are random to. There’s nothing systematic to be pulled out of it. But we’ll see.
UK: Professor one last question before we end. Have you been to India ever before?
EF: No. I’ve had many many Indian students always excellent students, but I’ve never been there. I don’t travel very well. I’ve never been to many places outside of Europe. I’ve lived 2 years in Europe.
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