Before giving your successful mutual fund managers—if you have any—a pat on the back for their stock-picking acumen, consider this: According to a recent study, which will be published later this year in the Journal of Finance, luck may have a lot more to do with returns than most investors care to acknowledge. The study, conducted by Eugene Fama from the University of Chicago and Kenneth French from Dartmouth, casts serious doubt on managers’ ability to generate alpha. In the investing world, alpha is generally used to measure the extent to which active managers can generate returns beyond what would be expected from their benchmark exposures.
As part of their research, the two professors ran 10,000 simulations. In doing so, they looked to create a world in which skill doesn’t exist. In other words, they assumed that alpha was always zero for funds—that active managers didn’t add or detract any value by way of their picks. As a result, for the purposes of the study, pure luck was the driving factor behind differences in returns. The professors’ universe consisted only of funds that invest primarily in U.S. stocks.
What they found is quite telling: In the luck-driven simulations, there were fewer bad funds and more high-performing funds than there are in the real world. “In short, the simulations tell us that for the vast majority of actively managed funds, true [alpha] is probably negative; that is, the fund managers do not have enough skill to produce risk-adjusted expected returns that cover their costs,” the professors note in a summary of their findings.
What about the “chosen” few managers who do, in the real world, generate astounding returns? “[The] historical performance of the top funds is about as we would expect from the extremely lucky funds in a world where true [alpha] is zero for all funds,” they write.
U.S. News recently spoke with Fama about the implications of the study. Excerpts:
Why did you decide to study luck?
This is the basic problem. You have several thousand mutual funds out there. When you look at the results over their whole histories, there’s a huge range of results. The winners are big winners and the losers are big losers. So the problem is to judge what the world would look like, what the cross section of performance would look like, if there were no skill in the population. That’s what this paper does, it constructs experiments that maintain the characteristics of mutual fund returns, but we set them up knowing that there is really no [skill].
So just how lucky are fund managers?
If you look at the top 10 percent, they’re [comfortably] outperforming their benchmarks. …Those are the people that people would write books about. But it turns out that if you look at the distribution that you’d expect by chance, you’d expect more of them out there.
As for the ones that do get good returns, does that mean they’re good stock pickers?
There are always people on the top; that’s the point. People make the wrong inference. There are people that are big winners, but there are fewer of them than you’d expect than if they were just lucky.
Can any managers truly be counted on to add alpha through skill alone?
You can’t tell from the net returns. Now if you give them back their fees and expenses and just look at their portfolio returns, then you find some evidence that there are funds out there that might have some skill, but it’s absorbed in fees and expenses.
What do your findings mean for the role of active management?
Don’t be misled by past performance. There’s lots of other evidence that shows that performance doesn’t persist--that the past winners aren’t the future winners and that basically what happens after you rank them as winners is random. And this is consistent with that: It’s basically saying that the winners are just lucky.
What about index funds and ETFs? Do you like them as options?
The general message is…whatever framework you use, whether it’s mutual funds…or ETFs, you want low-fee, passive funds, unless you feel like paying these active managers the fees for basically not having performance that can be documented.