This year’s Nobel Prize in Economics was given to Eugene Fama (University of Chicago), Lars Peter Hansen (University of Chicago) and Robert Shiller (Yale University) for their work on understanding how asset prices are determined.

This academic research has had a profound impact on investment practice in the developed world, particularly in North America and Europe, and is currently having a growing impact in Australia and Asia.

The greatest influence came from Fama’s initial studies in the 1960’s and 1970’s demonstrating the difficulty in predicting individual stock returns over the short run.

Countless studies since the 1970’s have confirmed the difficulty in “stock picking’’ and shown that even professional portfolio managers of actively managed mutual funds that “stock pick” will on average not outperform the broad stock market index.

These findings have resulted in index funds and Exchange Traded Funds (ETFs) playing an increasingly important role in investment practice. These are funds that track a particular index or asset class.

By 2012, these funds accounted for over 40 per cent of the worldwide flows into mutual funds, with over US$3.6 trillion of assets under management.

The rising trend into these funds is likely to continue as more investors become aware of the benefits these funds offer in competitive risk adjusted returns with very low management fees.

In addition to the Nobel Laureates findings that in the short term, stock return predictability is very limited, they also provided profound insights into the longer term predictability of asset returns.

Over medium term horizons such as five years, they demonstrated substantial predictability in asset markets such as stock markets and housing markets.

Robert Shiller’s 1980’s work in this area has been particularly influential and popularized in his bestselling investment classic entitled “Irrational Exuberance”. Shiller demonstrated that over longer horizons, stock markets and housing markets are predictable based on fundamentals such as firm earnings for stock valuations and household incomes for housing valuations.

However, over shorter horizons asset prices are prone to “fads’’ and overreaction to changes in fundamentals. Shiller has shown remarkable ability to identify bubbles in asset prices before they burst.  This includes the bubbles in the stock market in the 1990’s and housing markets around the world before the recent global financial crisis.

After winning the Nobel prize, Shiller warned that there are still many housing markets looking bubbly, including Australia. Hansen’s most influential contribution has been the development of a statistical method that has proved extremely useful in empirically evaluating asset prices.

Overall, these three economists have shaped the way asset prices are interpreted and how investment portfolios are constructed. In addition, they have provided important insights into the risk involved in investing in asset markets.

Dr Jonathan Reeves is a financial economist at the Australian School of Business, UNSW Australia.

Richard Holden and Justin Wolfers

Financial markets provide a useful reminder of just how humble we economists should be about our understanding of the world. The three winners of the 2013 Nobel Memorial Prize in Economic Sciences neatly capture this tension.

Eugene Fama is the intellectual godfather of the view that financial markets are efficient, while no one has done more than Robert Shiller to highlight their inefficiencies. Lars Peter Hansen developed statistical techniques that both sides have used to help resolve their differences.

The central issue is whether the prices of stocks, bonds and other financial assets reflect the workings of a well-functioning market. That is, do financial prices reflect the wisdom of crowds, or do they mirror popular delusions? The answer determines whether you should try to beat the stock market, whether the Federal Reserve should respond to rising housing prices, and how the U.S. should regulate financial markets.

Tests of market efficiency revolve around the question of whether future movements in stock, bond and housing prices are predictable. The basic logic is that prices in an efficient market already reflect all available information, so there shouldn’t be any existing information that can predict how they will change in the future.

Well, mostly. All economists believe that investors should demand higher returns for taking on more risk, and so the question is whether risk-adjusted price changes are predictable.

Stock-pickers around the world can attest that predicting price changes is difficult. Equally, with enough persistence, one can usually ferret out a few accurate predictions. Indeed, all three laureates have accumulated evidence consistent with the idea that stock-price movements are somewhat predictable. The real debate, then, is how to interpret this predictability.

In Fama’s telling, a stock price reflects the wisdom of crowds. Yes, there is evidence that sometimes share-price movements are predictable, but they are small and largely reflect compensation for greater risk.

Fama’s systematic studies of the performance of different stocks over time have revealed clear evidence that price changes are predictable. In particular, he and collaborator Kenneth French have shown that stocks of small companies and of those with high book-to-market values have historically yielded higher returns. Fama argues that this predictability isn’t evidence against market efficiency, rather that these are proxies for a stock’s riskiness. To him, these higher returns are simply a rational response to greater risk.

This perspective has had an important effect on the stock-picking community, where analysts are evaluated on the performance of their picks relative to the benchmarks that account for these risk factors.

Fama was also an early architect of financial “event studies,” compiling an impressive body of evidence showing that markets respond rapidly to new information. Even so, the observation that markets react quickly doesn’t mean that they are responding fully, or even rationally.

An important implication of the Fama view is that stock picking is a futile exercise. Investors who want to own stocks should instead buy low-cost index funds. This observation has led to an entire industry of such funds being created.

While Fama tended to focus on short-term changes in individual prices, Shiller focused on the bigger picture of asset prices — and over a longer term. And while Fama’s account of stock-price predictability emphasizes risk, Shiller puts human psychology at center stage.

Shiller has shown that stock prices are far too volatile to be consistent with market efficiency. The logic is simple: Because a stock is an entitlement to a company’s future dividends, a stock price should only fluctuate as the value of future dividends rises and falls. However, as any market-watcher knows, stock prices are incredibly volatile, even as dividends tend to be stable. The juxtaposition of these facts suggests that something beyond fundamentals drives stock fluctuations.

In Shiller’s telling, markets can be subject to extraordinary popular delusions and the madness of crowds, in which stock prices become unmoored from future earnings. Shiller has shown that when stock prices rise too far ahead of corporate earnings, then a correction is likely. In 1996, he issued a prescient early warning of the dot-com bust and, in an influential briefing at the Fed, persuaded then-Chairman Alan Greenspan to warn of “irrational exuberance” before the bubble burst.

Similar forces are at play in the housing market, where the ratio of house prices to rents can predict changes in home prices, much as the ratio of share prices to earnings predicts stock prices. This style of analysis led Shiller to call the housing bubble well before its implosion.

If the Fed were as capable as Shiller of spotting financial bubbles, it would surely be more active in trying to prick them. That it remains largely on the sidelines suggests that the Fed is modest about its ability to replicate Shiller’s uncanny accuracy.

Perhaps, then, the broader lesson is that Shiller teaches us to be on the lookout for when we’re gripped by a mass delusion. Numerous studies in behavioral finance, as well as the lessons of the 2008 financial crisis, have shown that providing people with accurate information may be the best remedy for mass delusion.

The insights of the third laureate, Lars Peter Hansen, are less well known beyond academia yet potentially more far-reaching. Hansen developed a widely used statistical technique called the generalized method of moments. The broader context is that a statistician must always make assumptions to transform raw data into useful insight. Hansen’s method broadened the assumptions that empirical researchers could rely on, thus allowing them to choose weaker assumptions. Or as he said this morning, “I think of it as showing how you can do something without having to do everything.”

Although Hansen developed his method in the context of trying to referee the dispute between market efficiency and inefficiency, it has been even more useful beyond that domain, and today is part of the statistical toolkit used in every part of economics.

With a little latitude one could summarize this prize as suggesting that financial markets are efficient (Fama), except when they’re not (Shiller), and that we have empirical evidence to prove it (Hansen). But there are also deeper lessons: This stuff is hard. Social science progresses slowly. Most important, we are still learning how and when financial markets generate wealth and provide economic stability and when they are a casino destabilizing the economy.

Richard Holden is a professor of economics at the University of New South Wales, Australian School of Business. Justin Wolfers is a fellow of the Brookings Institution, a professor of public policy and economics at the University of Michigan. A version of this opinion piece appeared on Bloomberg.

Geoffrey Garrett

Most commentary on the US government shutdown concerns the apparent disregard some pigheaded Republicans have for the harm it could do to the American and global economies. While the shutdown will likely be relatively short and its impact quite small, attention is already shifting to a potentially much more dangerous repeat performance over raising the debt ceiling in a couple of weeks.

No matter how ugly the politics gets over the next fortnight, and no matter how much the Tea Party cannot bear to see Obamacare implemented, good sense will most inevitably win out. The small number of moderate Republicans Obama needs will ultimately agree yet again to raise the debt ceiling rather than face the spectre of sovereign default by the world’s largest economy and its reserve currency, with Republican Speaker John Boehner already saying as much.

Budget and debt ceiling impasse is a very big story. But an even bigger one is quietly looming.

The Obama presidency may well soon be over, at least in terms of his ability to move the policy dial at home and abroad over the remaining three years he has in the White House.

When Obama was re-elected less than 12 months ago, his second term agenda was ambitious and clear.

First, domestic: Roll out Obamacare, regulate more tightly gun ownership to reduce senseless human carnage, give legal status to more than ten million undocumented migrants, and chart a long term path to a balanced budget via tax increases as well as spending cuts.

On the international front, Obama wanted to build on his first term’s ending of Bush’s wars in Afghanistan and Iraq by supporting the Arab Spring’s transition into stabler democracy and then pivoting his foreign policy away from the Middle East and towards Asia.

A year later, every element of that agenda is now in trouble if not yet in tatters.

Washington is grossly dysfunctional. Most of the blame lies at the feet of the Republican right that hates Obama with a rare passion.

But Obama shot to global prominence in 2004 as a uniter not a divider. His 2008 victory, his GFC stimulus in partnership with the Ben Bernanke’s Federal Reserve, and the passage into law of the most important health care reforms in 50 years, were all evidence that “yes, he could”.

No more, ever since the Tea Party insurgency helped the Republicans win control of the House of Representatives in 2010. Now they are determined to fight tooth and nail against what they and many voters consider the un-American policy lynchpin of Obamacare — mandating that all Americans take out health insurance. They cannot undo the legislation they despise, but they can make and have made forward movement – on anything – extremely difficult and very painful for Obama.

The president’s ballyhooed gun control push died with barely a whimper in Congress because opposition to Obama’s agenda extended beyond the Tea party, with salt rubbed into the wounds by the recent massacre on a US Navy base near Washington.

Immigration reform is proceeding at best at glacial pace, again with a reasonably broad coalition of Republicans and some conservative or endangered Democrats insisting that the border with Mexico must first be secured by more fences and walls as well as more law enforcement.

Obama’s vision of a grand bargain to stabilise the US budget for the long run continues to fall on deaf ears, with big budget deficits projected as far as the eye can see. Except extreme fiscal hawks like Paul Ryan who want to take health care off the government balance sheet by privatising it, no one has a plan to rein in health care costs that are almost double those of most western countries. Obama was able modestly to increase taxes on millionaires in the run-up to 2012. But no one has the stomach for the much broader and bigger tax hikes the US will need as ever more baby boomers retire.

On the foreign policy front, the government shutdown has now forced Obama to cancel next week’s trip to Asia. That means no APEC, no ASEAN forum, no East Asian Summit and no progress on the Trans Pacific Partnership for free trade for America’s proclaimed “Pacific president”. At the same time, China’s assertions of sovereignty in disputed parts of the East and South China seas are unabated, despite repeated US’s warning against Chinese maritime aggression.

More generally, crises continue to draw the US back into the Middle East, even if Obama would prefer to focus his strategic gaze on Asia.

All US combat troops have left Iraq and will soon exit Afghanistan. But it is hard to see that either country is in better shape now than ten years ago.

Obama has been associated with what became the Arab Spring since at least his 2009 Cairo speech that may well have played a part in inspiring it. After the success of the no fly zone in Libya Obama supported if not led, Egypt is again unstable and volatile, possibly the result of an old style military coup with the US sitting on the sidelines.

Syria’s bloody civil war is an ongoing human disaster. Obama’s call to arms after Bashar Assad’s chemical weapons attack on his own people was met with a divided Congress, a no vote from the US’s “special relationship” partner, the UK, and a weak United Nations deal brokered by Vladimir Putin. Leadership from behind, say Obama’s critics.

Who knows if Obama’s phone call with his new seemingly moderate counterpart in Iran will lessen its nuclear ambitions. Certainly Benjamin Netanyahu doesn’t think so, while Israel continues openly to defy Obama’s call to end settlement building in Palestinian territory.

Obama’s legacy will no doubt be debated for decades. An extraordinary orator who saved the US and the world from another Depression, ended George Bush’s much hated wars and enacted the biggest health care reforms in 50 years. A pretty good record, but mostly in his first term. Even Obama’s biggest boosters are not confident he will add materially to this list before he leaves the Oval Office.

All second term presidents become lame ducks at some point. But recent events at home and abroad suggest Obama’s requiem may come sooner than we could ever have imagined.

Geoffrey Garrett is Dean of the Australian School of Business at UNSW. A version of this post appeared in the Conversation.

Helen Hodgson

Self managed superannuation funds (SMSFs) have come under criticism from regulators amid concerns that the sector is over-investing in the residential property sector.

The profession has hit back at the criticism, saying that most SMSF borrowings do not relate to residential property, and that the surge in the cost of housing is not due to SMSFs. So what is going on?

There are two separate issues at play here. Firstly SMSFs are becoming more active investors, including in the residential property market; and secondly the rules restricting borrowing by a superannuation fund have been relaxed since 2007.

The problem arises at the intersection of these two trends, where residential property is being aggressively marketed to the SMSF market on the basis that it can borrow for the purchase.

The fundamental rule of superannuation, known as the sole purpose test, is that the core purpose of a superannuation fund is to provide benefits to its members in retirement. Risky investments are discouraged as this could compromise the ability of the fund to pay retirement benefits; and benefits to members are supposed to be deferred until retirement.

Prior to 2007 superannuation funds were not permitted to borrow, however the restriction could be circumvented by the use of instalment warrants, a financial instrument that allowed the fund to leverage to acquire assets, accordingly in 2007 the superannuation legislation was amended to allow superannuation funds to use such instruments to fund property acquisitions.

These changes were superseded in 2010 by the limited recourse borrowing provisions, which allow a superannuation fund to borrow to acquire an asset through a mechanism that ensures that the risk of borrowing is quarantined to the specific asset. This is intended to protect the remaining assets within the fund in the event of a default by the borrower.

It is within this framework that the concern over borrowings by SMSFs has arisen but there are several trends that coalesce around this issue. There has been a sharp rise in the number of Australians setting up SMSFs as many investors establish a self managed superannuation funds in order to manage their own investments, particularly in the wake of the GFC. This has been facilitated by the superannuation choice rules that allow a person to choose the superannuation fund their compulsory contributions will be paid into. Finally, Australians have always been attracted to bricks and mortar investments, and many investors lost faith in shares as the value decreased during the GFC.

The residential property market is already under pressure with concerns over affordability for home buyers. Activity by investors has increased due to the combination of low interest rates and increasing property values, and SMSFs are increasingly visible among investors.

The Reserve Bank, in its recent Financial Stability Review noted that the ability to borrow for investments has resulted in an increase in property holdings. It shows that SMSFs have a higher proportion of assets in property than other funds, although property, without differentiation between residential and commercial, still ranks fourth behind cash, Australian equities and “other” investment classes.

The Reserve Bank did not limit its concerns to bricks and mortar, but also indicated that hybrid securities were an emerging problem area. The SMSF Professionals Association of Australia (SPAA) claims that residential property is a minor element of the total SMSF investment market as most property held by SMSFs is commercial.

At 30 June, 11.7% of SMSF investments were in commercial property compared to 3.4% in residential property, and the latest Taxation Statistics show that less than half of 1% of all property investment was geared.

SMSF trustees need to be aware that it is not always a tax effective strategy to borrow to acquire property in a SMSF. Superannuation funds pay a concessional rate of tax, so negative gearing within a superannuation fund will often be less tax effective than if the member invested directly, outside the fund. The income available to make the payments will be primarily from the return on the asset, with the shortfall from other income, particularly member contributions to the fund, which are subject to the contribution caps.

Borrowing may allow the SMSF to leverage up an investment in the hope of receiving a higher capital gain when the property is sold. Capital gains will be exempt in a SMSF but only if the property is sold after the fund enters the pension phase, which may be many years down the track. Accordingly this is only likely to be tax effective if the member is approaching pension age.

The worrying trend identified by the Reserve Bank is the increased promotion of leveraged property purchases to SMSFs. Activity in the residential property market is also highly visible, due to the increasing number of SMSFs in the market, and many of the promoters of this strategy are not regulated by APRA.

It is this lack of supervision of this sector of the industry that is of most concern. Not only is this strategy pushing up the price of real estate, but it is exposing SMSF members to risk if property prices crash.

Helen Hodgson is a senior lecturer in the school of taxation and business law at the Australian School of Business. A shorter version of this opinion piece appeared in the conversation.

Gordon Mackenzie

The debate about whether self managed superannuation funds minimise tax or are taxed differently to other types of funds misses a key point.

Our view is that they are not minimising tax, nor is there any difference in way they pay tax. Any differences between tax of SMSFs and other types of super funds just reflects different legal structures and not any difference in the tax laws.

The Australian School of Business at the University of NSW is just finalising some research about the views on tax of the chief investment officers (CIOs) of some of Australia’s largest superannuation funds. In addition, through our Masters programs, we have been heavily involved with the tax practitioners for SMSFs, so we have some insight into how both of these super funds are taxed.

At the outset the actual tax laws by which both are taxed are identical but with one exception, which is an anti avoidance rule that only applies to SMSFs. Interestingly, that rule gives the larger funds a marketing advantage.

One theme that has emerged in our research is that the CIO’s of large funds are pretty tax savvy.

SMSF practitioners are equally tax savvy but what was surprising to us is that they are conservative in the way they manage SMSF tax because their clients will not pay them to have a fight with the Australian Tax Office (ATO) and, also, their clients want to sleep at night and not worry about a knock on the door from the tax office.

Sally Patten (AFR Weekend, September 28) makes four good points about SMSFs. First, that no tax is paid when a fund goes from accumulating to paying a pension, however large funds can actually charge the member for tax at that point. Again, there is no law that says that and nor should there be. It is possible to restructure so that they do not pay tax that technically they do not have to pay, as some large funds have in fact done.

Secondly, we found that large funds do participate in share buy backs. It is just not an issue for them.

Patten also highlights that SMSFs can invest in residential property but that is not a tax issue, it is an investment class issue. It is because people who set up a SMSF better understand that class of investment. Again, the ability of a SMSF to leverage is a regulatory issue, not a tax matter. Sure, it can have a tax affect but the main point is that it does not increase risk. Specifically, none of the funds other assets than what it purchased with the loan are at risk to the lender. However, having said that we do have some concerns that leverage can affect tax equity, but that is a different argument.

Finally, the ATO is the lead regulator of SMSFs not just for tax but because of the number of SMSFs (500k+), which is a volume business and the ATO is good at managing volume. Also, regulation by the ATO of SMSFs is different to regulation by APRA of all the other super funds. ATO regulates by disclosure, where the private sector audit profession reports breaches by SMSFs to the ATO. APRA, on the other hand,provides full prudential regulation, where the actual financials of the funds are interrogated against particular standards set by APRA. The reason for the difference is that where someone is managing money for third parties you need a more robust regulatory system than when all the customers (fund members) are also involved in running the fund, when you need less regulation.

Overall then what we have found so far is consistent with tax expert Michael Rice’s observations: the tax rules are the same for each type of super fund (with that one exception, which benefits large funds) but you get different tax efficiencies depending on whether the assets in the fund are pooled, as for large funds, or, to use technical speak, “hypothecated” (which means that they are directly related to the member’s account) for SMSFs.

This has nothing to do with tax avoidance it is simply a function of the legal structure of the super fund.

Gordon Mackenzie is a Senior Lecturer and Program Convenor at the Australian School of Taxation and Business Law at the Australian School of Business. Gordon Mackenzie has given submissions to Henry Tax Review Panel on Resolving the Tax Inefficiency of Losses, and the Cooper Review on Tax Governance of Superannuation Funds, into the structure and operation of Australia’s superannuation system.

A version of this opinion piece appeared in the Australian Financial Review.