Swedroe: Sorting Luck From Skill

May 15, 2017

In many walks of life, trying to discern the lucky from the skilled can be a difficult task. For example, it seems like every time a professional sports draft occurs, debate again flares up over whether the evaluation of college (or even high school) athletes is an exercise in skill or in luck.

Were the Portland Trail Blazers unskilled in the 1984 NBA draft when they selected Sam Bowie with the second overall pick, just ahead of Michael Jordan? Or were they just unlucky? (Bowie went on to an uneventful and injury-plagued career, while Jordan led the Chicago Bulls to six championships and is considered by many to be the greatest basketball player ever.)

The point is that sometimes it’s not easy to distinguish luck from skill. This difficulty extends to the evaluation of active mutual fund managers. With that in mind, we’ll review the academic literature on the subject of luck versus skill in mutual fund performance. We will examine the results of eight studies, including one that is surprising and provides important insights. The first study is by Bradford Cornell.

A Study Of Skill And Serendipity
Cornell, who contributed to the literature with his study “Luck, Skill, and Investment Performance,” which was published in the Winter 2009 issue of The Journal of Portfolio Management, noted: “Successful investing, like most activities in life, is based on a combination of skill and serendipity. Distinguishing between the two is critical for forward-looking decision-making because skill is relatively permanent while serendipity, or luck, by definition is not. An investment manager who is skillful this year presumably will be skillful next year. An investment manager who was lucky this year is no more likely to be lucky next year than any other manager.” The problem is that skill and luck are not independently observable.

Because this is the case, we are left with observing performance. However, we can apply standard statistical analysis to help differentiate the two, which is precisely what Cornell did. He used Morningstar’s 2004 database of mutual fund performance to analyze a homogenous sample of 1,034 funds that invest in large-cap value stocks.

Cornell’s findings were consistent with previous research that showed the great majority (about 92%) of the cross-sectional variation in fund performance is due to random noise. According to Cornell, this result demonstrates that: “most of the annual variation in performance is due to luck, not skill.” He concluded: “The analysis also provides further support for the view that annual rankings of fund performance provide almost no information regarding management skill.”

Our second study is by Eugene Fama and Kenneth French, who contributed to the literature with their study “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” which was published in the October 2010 issue of The Journal of Finance. They found fewer active managers (about 2%) were able to outperform their three-factor (beta, size and value) model benchmark than would be expected by chance.


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