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Rarer Than Rare

Eugene Fama and Kenneth French's study on the distribution of manager skill.

Samuel Lee, 04/22/2014

A version of this article was published in the July 2013 issue of Morningstar ETFInvestor. Download a complimentary copy here.

Life would be a lot easier (and more interesting) if everyone had a number floating above their heads quantifying something important about them--it could be kindness, trustworthiness, or whatever. Because they don't, we rely on signals that may or may not be correlated to the qualities we care to learn about. Fortunately, personality traits are highly persistent. Five years from now, the odds are good that a kind person will still be kind. Cause and effect is clean and reliable.

Because this type of reasoning is so useful in everyday life, investors can't help but apply it to investing. They mistakenly infer that a manager or asset with good past performance will have good future performance. Of course, anyone who knows anything about investing pays lip service to the notion that they know this isn't true, but their behavior indicates otherwise. Every manager has a performance record, and most investors cannot resist treating it as if it were a number floating above the manager's head indicating his true merit.

Sadly, we will never see that number. Past performance clearly isn't it, because as a whole, managers with the best records don't continue to outperform in a reliable way. A manager's true skill, or alpha, expressed as an annualized return value, is his expected outperformance if he were to manage a portfolio for a very long time. In other words, if a manager's true alpha is 2%, then he will beat the market by 2 percentage points annualized over a long enough horizon. This number exists only in the mind of God.

But what if we could figure out the distribution of that true number in the population? It would be like taking a small peek behind the veil. While knowing the distribution won't help you pinpoint any particular managers, it could help you figure out how much evidence you need to conclude that any particular manager is truly skilled.

Eugene Fama and Kenneth French took a stab at this question in a 2010 study, "Luck Versus Skill in the Cross-Section of Mutual Fund Returns." In setting up the study, they restricted themselves to equity mutual funds that existed for at least eight months during the period from 1984 to 2006 with at least $5 million (in 2006 dollars) in assets.

Fama and French then set out to answer an interesting question: What would that sample of funds have looked like if none of their managers had a whit of skill? To do this, they stripped out the above-benchmark return of each fund. Of course, doing this doesn't really tell you anything by itself. Remember, they were trying to figure out the distribution of true skill, and this can't be found by looking at any particular manager's realized performance, which is the product of a tiny amount of skill and a huge amount of luck.

To generate their own luck, they created a simulation of the sample by randomly selecting the monthly returns of each fund. The simulation was like an alternate universe in which no mutual fund manager is skilled. They repeated the simulation 10,000 times.

Samuel Lee is an ETF Analyst with Morningstar.

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