Are Winners Skilled or Lucky?
The foundation of Truepoint’s investment philosophy has always been, and will always be, rooted in the substantial academic research and empirical evidence of the financial markets. It is this information that strongly supports a focus on portfolio construction and the utilization of low-cost, passively managed investment vehicles.
Two of the most prominent researchers in this field are Eugene Fama, professor of finance at the Booth School of Business at the University of Chicago, and Kenneth French, professor of finance at Dartmouth College’s Tuck School of Business. Their most recent study, “Luck versus Skill in the Cross Section of Mutual Fund Returns,” analyzed 10,000 performance simulations to evaluate the presence of skill among active managers. The study data is based on the actual returns of 3,156 U.S. stock mutual funds from 1984 to 2006.
While about 70% of actively managed funds underperformed the market, the analysis suggests that most of the funds achieving some level of outperformance did so simply due to chance rather than skill. In fact, the professors conclude that only zero to 3% of active managers exhibit the skill sufficient to outperform a comparable efficiently managed passive fund.
The fact that up to 3% of active fund managers may possess the skill necessary to overcome their costs suggests that it is possible to select a manager with the ability to outperform the market. However, there’s a catch: according to the professors, the very few highly skilled managers are indistinguishable from those managers who do extraordinarily well by chance. Therefore, attempting to identify a truly exceptional active manager ends up being a matter of very low-probability guesswork. And those investing with a top-performing active manager run the risk of being around when the luck runs out.
Professors Fama and French explain that going forward they expect a portfolio of low-cost index funds to perform about as well as a portfolio of the top three percentiles of past active winners, and better than the rest of the active fund universe. In an interview with MarketWatch, Fama suggested that the continued faith in active management is due to both the mutual fund industry’s marketing efforts and the complicity of mutual fund rating agencies, whose existence is based on the assumption they can identify the best funds.
The conclusions of this study are consistent with that of many prior academic studies favoring the use of low-cost, passively managed funds. Ongoing, rigorous research such as this further strengthens the underlying rationale for our investment philosophy and process. However, we are committed to regularly reviewing the latest in financial market and investor research, and if new evidence ever points to a superior approach, we will adjust our strategy accordingly.