Skill or Luck?
If you place 50 active fund managers in the room and say, “imagine all the managers in this room, make up the whole market” and then ask, “so who in this room only will outperform this market?”
Amazingly, and perhaps not surprisingly, they will all put up their hand.
Now these fund managers are quite smart, right?
So, you have to ask the question again. Remember, just in this room, who will outperform? Again, they all put up their hands.
Mathematically we know that not all of them can outperform. There is a buyer and seller for each transaction.
Decades of research illustrate that this occurs on a grand scale, across global markets. Outperforming is very hard, and most active managers simply never have outperformed and never will.
Markets are actually really efficient at disseminating information and the prices we see are fair. In fact, you could argue that the only way to outperform consistently would be to:
- Use inside information (illegal)
- Make up your numbers (illegal)
- Rely on a market that is not efficient and does not have fair processes. But who would invest in that market?
Need some more evidence? (I always do!) The paper below from the Journal of Finance 2010 by Lauret Barram, Oliver Scaillet, and R Wermers concluded that when a fund manager has a statistically different performance to the fund’s benchmark, there are two explanations – it could be Skill or Luck.
So, which one is it? Using a sample of 1456 actively traded managed US equity funds between 1975 and 2006, the authors found that the total observed alpha (or what the industry calls outperformance) was:
- 76.6% had zero alpha! (i.e., added no value)
- 21.3% had negative alpha! (i.e., subtracted value!)
- Leaving 2.1% with alpha!
So, if you are using an active manager or are considering using one, it’s likely you won’t have a great outcome.
You can read the whole paper here.
Here’s a quick excerpt:
1.”Our analysis of the performance of the mutual fund industry shows that approximately 76.6% of All funds have zero alphas. This confirms the predictions of the Berk and Green (2004) model, asserting that, in equilibrium, open-end mutual funds yield no performance. Among the remaining funds, 21.3% of them yield negative alphas. It implies that the average negative alpha documented in the previous literature does not reflect the performance of the majority of funds but is rather driven by a minority of 20%. Finally, we find a tiny proportion of 2.1% of funds with positive alphas.”
To take control of your finances and learn more about investments than most financial planners dare to discover check out Scientiam for more readings and insights on how markets really work and how as an investor you can learn how to really invest and not gamble.
It’s your future.
Here’s to smart investing using science not guesswork.
- Wermers, R., Scaillet, O., and Barras, L. July 2006. False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas. The Journal of Finance, 65: 179-216. fdrperformance3b.dvi (mit.edu)
