Eugene Fama

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Eugene Fama (1939 - ) is known for his work on portfolio theory and asset pricing, both theoretical and empirical. He earned his undergraduate degree in French from Tufts University in 1960 and his Ph.D. from the University of Chicago in economics and finance. He has spent most of his teaching career at the University of Chicago.

His Ph.D. thesis, which concluded that stock price movements are unpredictable and follow a random walk, was published as the entire January, 1965 issue of the [Journal of Business], entitled The Behavior of Stock Market Prices. That work was subsequently rewritten into a less technical article, Random Walks in Stock Market Prices, which was published in [Financial Analysts Journal] in 1966 and Institutional Investor in 1968.

Fama is most often thought of as the father of efficient market theory. In a ground-breaking article in the May, 1970 issue of the [Journal of Finance], entitled Efficient Capital Markets: A Review of Theory and Empirical Work, Fama proposed two crucial concepts that have defined the conversation on efficient markets ever since. First, Fama proposed three types of efficiency: (1) strong-form; (ii) semi-strong form; and (iii) weak efficiency. Second, Fama demonstrated that the notion of market efficiency could not be rejected without an accompanying rejection of the model of market equilibrium (e.g. the price setting mechanism). This concept, known as the "joint hypothesis problem," has ever since vexed researchers.

In recent years, Fama has become controversial again, for a series of papers, co-written with Kenneth French, that attack and seemingly overturn the notion of market-efficiency. These papers describe two factors above and beyond a stock's market beta which can explain differences in stock returns: market capitalization and "value".

This willingness to let the data speak for itself is the ultimate defining characteristic of Eugene Fama, much more so than any one theory or set of results.

Additionally, Fama co-authored the textbook The Theory of Finance with Nobel Memorial Prize in Economics winner Merton H. Miller. He is also the director of research of Dimensional Fund Advisors, Inc., an investment advising firm with $102 billion under management (as of 2006). One of his children, Eugene F. Fama, Jr., is a vice president of the company.

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Fama and French Three Factor Model

In the portfolio management field, Fama and French developed the highly successful three factor model to describe the market behavior.

CAPM uses a single factor, beta, to compare a portfolio with the market as a whole. But it oversimplifies the complex market. Fama and French started with the observation that two classes of stocks have tended to do better than the market as a whole: (i) small caps and (ii) stocks with a high book-value-to-price ratio (customarily called value stocks; to be differentiated from growth stocks). They then added two factors to CAPM to reflect a portfolio's exposure to these two classes: [r-R_=\beta_(K_-R_)+bs\cdot SMB+bv\cdot HML+\alpha]

Here r is the portfolio's return rate, [R_] is the risk-free return rate, and [K_] is the return of the whole stock market. The "three factor" [\beta] is analogous to the classical [\beta] but not equal to it, since there are now two additional factors to do some of the work. SMB and HML stand for "small [cap] minus big" and "high [book/price] minus low"; they measure the historic excess returns of small caps and "value" stocks over the market as a whole. By the way SMB and HML are defined, the corresponding coefficients bs and bv take values on a scale of roughly 0 to 1: bs = 1 would be a small cap portfolio, bs = 0 would be large cap, bv = 1 would be a portfolio with a high book/price ratio, etc.

The three factor model is gaining recognition in portfolio management. Morningstar.com classifies stocks and mutual funds based on these factors. Many studies show that the majority of actively managed mutual funds underperform broad indexes based on three factors if classifed properly. This leads to more and more index funds and ETFs being offered based on the three factor model.

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