Presence of Luck Vs Skill

Introduction

In 2010, Fama and French develop on the debate of the presence of skill and luck within actively managed funds. Their findings were reviewed by the cross-reference of other articles dating from 1995 to 2016. The review is broken into the main argument of whether luck or skill is present, following on with how these funds perform compared to benchmarks and the question as to why they still exist.

Presence of Luck and Skill

Grinblatt et al (1995) concluded through the usage of momentum measures, time-series regressions and cross-sectional regressions of fund performance that mutual funds are inclined to purchase past winners discrediting the stock picking skill as they stick to familiarity.

Similarly, Carhart (1997) analysed funds between 1962 to 1993, grouping them into deciles. In testing the ability for fund managers to consistently earn abnormal returns, Carhart came to the conclusion that 46% of this abnormal return was credited to the 1-year momentum factor, which is the continuation of returns due to the previous year. This resulted in the slight discrediting of abnormal returns being due to skill as he believes, similarly to Grinblatt et al (1995), that fund manager’s performance is due to identifying past winners rather than actual stock picking skill.

Building on Carhart’s model, Bollen and Busse (2004) used an extended period of measurement. Results show no evidence of superior ability after accounting for the momentum factor which is proven through their inability to generate abnormal returns for long periods. However, doing the same for short and medium terms, it can be seen funds were able to generate these abnormal returns, as Carhart showed.

Kosowski et al (2006) took this further by applying the four-factor regression model to bootstrap simulations, involving randomly simulated runs of U.S. equity fund returns. The bootstrap simulations allow for more reliable results due to the ability to test larger sample sizes whilst randomly assigning data to tests. By doing this, they concluded only the top 5% managers were able to outperform the benchmark of passive funds once costs were deducted on a consistent basis. Therefore, disagreeing with the previous papers by concluding top managers outperform due to skill rather than other factors such as random chance or the momentum factor. Using the same data as Kosowski et al (2006), Cuthbertson et al (2008) are in agreeance as they find the top 5%-10% of managers have skill as they are able to do it consistently.

Using the same empirical methods applied in Kosowski et al (2006), Fama and French (2010) applied bootstrap simulations and time-series regressions for U.S. equity funds from 1984 to 2006. By comparing the estimated alphas of time-series regressions to actual alphas from bootstrap simulations, they conclude that very few active funds are skilled enough to create returns above the benchmark after fees. However, the ability of funds to significantly outperform is due to a combination of luck and skill.

Agyei-Ampomah et al (2015) used bootstrap simulations, backing up the findings through three-factor and four-factor regression model. They found due to asymmetrical information, fund managers were able to demonstrate skill in small and medium cap equity funds due to the skill of analysing this information. Taken further by Liebscher and Mählmann (2016) who used the less efficient syndicated loan market to prove that inefficiently priced markets provided the fund managers opportunities to demonstrate skill through persistence. However, Agyei-Ampomah et al and Liebscher and Mählmann find in more efficient markets managers are not able to generate consistent abnormal alphas. If abnormal alphas are achieved, crediting it to luck.

Studies from 1995 to 2004 lean towards the discrediting the presence of skill amongst fund managers for reasons such as the momentum factor and the inability to generate abnormal returns over a long period of time. However, by 2006 the previous regression models were taken further with the introduction of bootstrap simulations, leading to new findings regarding the skill and luck of fund managers. The majority of research shortly after find evidence of fund manager skill through persistent abnormal returns amongst the top fund managers. In addition, the returns of the extreme tails of the funds can be accredited to a combination of skill and luck. By 2016, through examining the efficiency of different markets, research has come to the conclusion that fund managers possess skill.

Average Performance of Funds

Wermers (2002) identified on average mutual funds outperform the market index by 1.3% before costs are deducted. Once the expenses and transaction costs are subtracted, the active funds net return is roughly equal to the market index. Berk and Green (2004) theorise that investors interpret past performance as a signal of future success. In reaction to this, they re-allocate capital to past performers. Thus, managers charge higher fees leading to a net zero return, eliminating consistently generated abnormal returns. Fama and French (2010) note the average U.S. equity fund are below the benchmark return after costs are deducted. Berk and Binsbergen (2015) proved Berk and Green’s theory, concluding investors are able to identify and reward skilled active managers, consequently bringing the average abnormal return close to zero.

Why are Active Funds Still Here?

Gruber (1996) theorises that mutual funds are preferred over passive funds for four primary reasons as follows; customer service, low transaction costs, diversification and professional management. Professional management is the only service which differentiates active funds to passive funds, but investors are unaware that the first three reasons are also present within passive funds. Investors misjudge the added value of professional management, they believe it can be highly priced due to abnormal returns, which are in reality are not manifested.