Wednesday, June 10, 2009

Yes, Your Favorite Hedge Fund Manager Is Probably Just Lucky

ClusterStocks' Henry Blodget pointed this out yesterday: The actual link is from Ken French, so you know it is good!

Yes, Your Favorite Hedge Fund Manager Is Probably Just Lucky: "Your favorite hedge fund manager has walloped the market by 5% per year for the past 10 years, so he's obviously a genius, right?

Actually, no. He had a one-in-five chance of doing that just by throwing darts."

From the April 29th Q&A with Ken French:

"If we pretend his returns are normally distributed, the probability that his average abnormal return exceeds 5% per year for a ten year period is more than 20%. In other words, in a group of hedge fund managers with standard deviations of 20%, we expect one in five to have a ten-year average annual abnormal return of at least 5%—even if none actually have any skill. We expect one in twenty of the unskilled managers to produce a ten-year average annual abnormal return of at least 10%."

When you consider large number of funds and that many underperforming funds "drop out" of samples (sure not for academic papers anymore, but in reports and marketing it is still a major issue), it is easy to see why many believe they (or their fund managers) have the ability to outperform.

2 comments:

Highgamma said...

Is your comment on dropouts weighted based upon assets under management? Most hedge fund investors have their money with the big funds. Are all those big funds lucky?

FinanceProfessor said...

Not all, but I would be willing to bet that many are.

But you are definitely right I should have specified that closed funds etc tend to be smaller.

But put another way, the more successful ones (lucky?) do attract more money and are larger.