Are market-beating fund managers truly skilled or just lucky?

By Mark Hulbert

The case for index funds strengthens against the reality that most managers underperform

For how many years must an investment manager beat the market to satisfy statisticians at the 95% confidence level that genuine market-beating ability exists?

The answer is a long, long time - longer than most investment managers' careers. In practical terms, this means you'll always be choosing between managers without statistically significant evidence of whether any of them have market-beating ability.

The required number of years depends crucially on two assumptions: The first is the average margin by which the manager beats the market ("alpha"), and the second is the volatility of returns. For a manager with an average alpha of 5% and whose standard deviation of annual returns is 20% (slightly more than the market, but same order of magnitude), the required number of years is 64.

You can quibble with the particular assumptions used in this example, but you'd be hard-pressed using reasonable ones to come up with a number much lower than 64. Advisers learn in CFA training that the required number of years increases as the manager's alpha decreases and the standard deviation of returns goes up. In almost all cases, even managers at the top of the long-term performance scoreboards have lower alphas and higher standard deviations.

Consider the U.S. stock fund in first place for performance since the late 1960s: Fidelity Magellan FMAGX. Based on calendar-year returns since 1969, the fund's alpha relative to the S&P 500 SPX is 3.5%, with a standard deviation of annual returns of 24.2%. (These numbers are based on data from investment researcher Morningstar Direct.)

Assuming the fund is able to continue producing a return in future years with a similar alpha and standard deviation, it would take well over 100 years to conclude at the 95% confidence level that it has genuine market-beating ability. (This example ignores the fact that the fund has had several different managers over the years.)

No manager's investment career lasts more than a century, needless to say. And even if you could find a manager whose long-term performance satisfies the 95% confidence-level standard, the odds are overwhelming that they will be close to retirement.

The upshot is that you have to choose a manager before you have statistical confidence that any prior market-beating performance was more than just luck. On the one hand, that doesn't mean you should pick a manager at random. There is still a higher probability that a manager who's beaten the market, even for only a couple of years, has genuine ability than one who's lost over that same period.

On the other hand, these results remind us how much noise there is in investment performance. Because of that noise, it's incredibly difficult to separate ability from luck.

The conclusion many draw from this analysis is that we should simply invest in broad index funds. While this forfeits the remote possibility of beating the market over the long term, you gain the confidence of not lagging the market.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

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-Mark Hulbert

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05-25-24 1148ET

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