Swedroe: True Alpha A Rare Thing

June 20, 2018

Qiang Bu, author of the study “Do Persistent Fund Alphas Indicate Manager Skill?”, which appears in the Fall 2017 issue of The Journal of Wealth Management, examined whether long-term fund alphas come from manager skill or luck.

His study covered the 20-year period 1993 through 2012, and included 476 U.S. mutual funds that existed through the full period. (Note there were more than 1,000 U.S. equity funds at the start of the period.) Using a group of bootstrapped winner funds as his benchmark, he compared this benchmark to actual winner funds over the period.

Bu found evident differences among funds with regard to return distribution properties, market exposure, alpha consistency and portfolio holdings. In addition, persistent winner funds exhibited fund-specific characteristics distinct from those of other funds. He concluded that persistent fund alpha is earned by manager skill instead of pure luck.

The following table presents the study’s list of winner funds that produced a statistically significant (at the 5% level) 20-year alpha and their associated annual four-factor (market beta, size, value and momentum) alphas. The t-stats of the alphas were all between 2.2 and 2.9.



While the average annual alpha of 3.3% for the winners is very impressive, perhaps the most interesting finding is that, of the more than 1,000 actively managed funds that existed at the start of the 20-year period, Bu was able to identify just eight that produced statistically significant alphas at the 5% level. Using that same 5% level of confidence, we randomly would expect to have found 25 that outperformed. Thus, only about one-third of the number of funds we should expect to outperform purely by chance actually did.

Outperformance Less Than Randomly Expected

This finding of fewer statistically significant winners than would be randomly expected is consistent with prior research.

For example, in 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, Eugene Fama and Kenneth French found fewer active managers (about 2%) were able to outperform their three-factor (market beta, size and value) model benchmark than would be expected by chance.

Similarly, in his August 2016 study, “Mutual Fund Performance through a Five-Factor Lens,” which covered 3,870 active funds over the 32-year period 1984 to 2015, Philipp Meyer-Brauns of Dimensional Fund Advisors found that, after benchmarking returns to the Fama-French five-factor model—adding profitability (RMW, robust minus weak) and investment (CMA, conservative minus aggressive)—to the Fama-French three-factor model, just 2.4% of the funds had alpha t-stats of 2 or greater, less than the 2.9% we would expect by chance.

Meyer-Brauns extended his work in his March 2017 paper, “Luck vs. Skill across Different Fund Categories.” He examined four separate categories of U.S. equity mutual funds (large-cap value, large-cap growth, small-cap value and small-cap growth) over the period January 2000 through June 2016. His goal was to determine whether active managers’ ability to outperform the Fama-French five-factor model varies across fund categories.

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