Dice Stack

Luck vs. Skill Across U.S. Equity Asset Classes

Dice Stack

When it comes to analyzing active management performance, it is important to understand the role that luck can play over various time horizons. Given the randomness of markets around the world, there is always a subset of managers who will outperform a given benchmark by chance.

Eugene Fama and Ken French published a research paper entitled “Luck vs. Skill in the Cross-Section of Mutual Fund Returns,” in 2010 that attempted to shed light on the role of luck in explaining active fund performance. They analyzed the performance of 3,156 different actively managed mutual funds from 1984 to 2006. After controlling for the known dimensions of expected return (market, size, and relative-price) using the Fama/French 3 Factor Model, they examined the distribution of alphas as well as their t-statistics. Then, they compared the results against a normal distribution of t-statistics of alpha that are expected to happen by random chance based on similar characteristics. What they found is that the distribution of t-statistics lied to the left of the distribution showing random chance outcomes. What this suggests is that, net of fees, most active fund managers do worse than what is expected by random chance. If there are managers with superior investment management skill, they are hidden by the large number of managers with inferior skill.

The practical implication for investors is that it is hard to decipher whether the active management community is displaying genuine skill or if the community just happens to be on the good side of Lady Luck. If it turns out that their performance is due to luck, then it is unlikely to persist into the future and, therefore, be a profitable investment strategy for investors compared to a simple index fund.

Dimensional Fund Advisors[1] updated Fama and French’s original article in 2016, updating their data set through 2015 and updating their model to the recently developed Fama/French 5 Factor Model, which includes the addition of the profitability and investment factors. They came to the same conclusion as Fama and French. The distribution of t-statistic of alphas lied to the left of the distribution that is expected by random chance. See exhibit below.



Building upon their analysis from last year, Dimensional recently produced a similar paper[2] examining active manager performance at the asset class level. Looking at U.S. Large Cap Growth, U.S. Large Cap Value, U.S. Small Cap Growth, and U.S. Small Cap Value, they determined that the same overall trend was consistent across all asset classes: The distribution of active manager performance lied to the left of the distribution we would expect by random chance. See exhibit below.

Again, the overall importance of this analysis for investors is not to determine whether or not there are skilled managers that can outperform the market. It is possible. The point is that it is hard to tell. Like most individual research pieces, this is just another example of evidence that supports a bigger philosophical idea that markets seem to be very efficient, are unpredictable, and are hard to beat. It would be prudent for investors to embrace the market and allow it to work for them, rather than pay more in fees and overall costs in attempts to beat it.

[1] Meyer-Brauns, Philipp. “Mutual Fund Performance Through a Five-Factor Lens.” Dimensional Fund Advisors, August 11, 2016.

[2] Meyer-Brauns, Philipp. “Luck vs. Skill Across Different Fund Categories.” Dimensional Fund Advisors, March 9, 2017.

Source: Dimensional Fund Advisors LP.
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