Friday, May 08, 2009

SSRN-Luck versus Skill in the Cross Section of Mutual Fund Alpha Estimates by Eugene Fama, Kenneth French

Ok, for starters It was from Fama and French. So even if I said nothing more, you would probably assume it was good. Like most of their work, this one is thought-provoking and insightful. Their interest this time is in Mutual Fund performance.

Their findings? More evidence that markets are tough to beat.

SSRN-Luck versus Skill in the Cross Section of Mutual Fund Alpha Estimates by Eugene Fama, Kenneth French:

From the abstract:

"Bootstrap simulations produce no evidence that any managers have enough skill to cover the costs they impose on investors. If we add back costs, there is some evidence of inferior and superior performance (non-zero true alpha) in the extreme tails of the cross section of mutual fund alpha estimates. The evidence for performance is, however, weak, especially for successful funds, and we cannot reject the hypothesis that no fund managers have skill that enhances expected returns."

A look-in:
"The VW portfolio of funds that invest primarily in U.S. equities is close to the market portfolio, and
estimated before costs, its α relative to common benchmarks is close to zero. Since the VW portfolio of funds
produces α close to zero in gross (pre-cost) returns, α estimated on net (post-cost) returns to investors is
negative by about the amount of costs. And since mutual funds in aggregate produce α close to zero before
costs, equilibrium accounting allows us to infer that in aggregate other active managers do the same.

This latter parts rests on the assumption that if mutual fund performance was negative, "other" active managers would be beating the market. (it should be noted that this is not evidence that others do not beat the market, only that if they do, those gains on average must come from a group other than mutual fund managers.)

Of course this is just an aggregate test. The next step is to look to see whether individual fund managers beat the market:

"The aggregate results imply that if there are mutual funds with positive true α, they are balanced by
funds with negative α. We test for the existence of such funds. The challenge is to distinguish skill from luck.
Given the multitude of funds, many have extreme returns by chance. A common approach to this problem is
to test for persistence in fund returns, that is, whether past winners continue to produce high returns and losers
continue to underperform (for example, Grinblatt and Titman 1992, Carhart 1997)

.....We take a different tack. We use long histories of individual fund returns and bootstrap simulations of
return histories to infer the existence of superior and inferior managers. We compare the actual cross-section
of fund α estimates to the results from 10,000 bootstrap simulations of the cross-section.

The findings? From the conclusion:
For funds on average and the average dollar invested in funds underperform three-factor and four-factor benchmarks by about the amount of costs (fees and expenses). Thus, if there are fund managers with skill that enhances expected returns relative to passive benchmarks, they are offset by managers whose stock picks lower expected returns. We attempt to identify the presence of skill via bootstrap simulations. The tests for net returns say that even in the extreme right tails of the cross-sections of three-factor and four-factor t(α) estimates, there is no evidence of fund managers with skill sufficient to cover costs

Good stuff as always....

Cite: Fama, Eugene F. and French, Kenneth R.,Luck versus Skill in the Cross Section of Mutual Fund Alpha Estimates(March 9, 2009). Tuck School of Business Working Paper No. 2009-56. Available at SSRN:

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