Previously, I reviewed several academic studies that evaluate whether luck or skill is playing a part in mutual fund performance, hoping to glean some insight on evaluating active mutual fund managers. Today we’ll continue our look at the research with a focus on a seventh and eighth study on the topic of luck versus skill.
Skill And The 6-Factor Model
Our seventh study is the April 2016 paper “Skill and Persistence in Mutual Fund Returns: Evidence from a Six-Factor Model.” The authors, Bradford Jordan and Timothy Riley, contribute to the literature by extending the analysis on fund performance to a six-factor model, adding profitability and investment to the Carhart four-factor model (market beta, size, value and momentum). Their data set covers the period 2000 through 2014. Following is a summary of their findings:
- In the best-performing ventile (top 5%) of funds, the average alpha is -0.52% per year (t-stat = -0.35) using the four-factor model, but increases to 3.73% per year (t-stat = 3.44) with the addition of RMW and CMA.
- In the worst-performing ventile of funds, the average alpha decreases from -2.14% per year (t-stat = -1.92) when using the four-factor model to -2.99% per year (t-stat = -3.28) when using the six-factor model.
- The difference in six-factor alpha between the best and worst ventiles is economically large, at 6.73 percentage points per year, and highly statistically significant (t-stat = 4.70).
Based on these findings, Jordan and Riley concluded: “Using the four-factor model, we find very limited evidence of positive alpha after fees beyond that attributable to luck. However, the addition of RMW and CMA to the model leads to a very different conclusion. Using the six-factor model, we show that a significant percentage of mutual fund managers display skill by delivering positive alpha after fees that cannot be attributed to luck. Beginning at about the 85th%ile of fund performance, the t-stats associated with after-fee fund alphas begin to exceed what we would expect from luck alone.”
While this sounds like great news for investors in the top-performing funds, another finding was quite surprising—one with negative consequences not highlighted by the authors. In fact, Jordan and Riley state: “The best performing funds create on average about $3 billion per year in value for investors.”
Unfortunately for investors in these top-performing funds, Jordan and Riley also found that the top performers have large negative exposures to RMW, CMA and HML (high-minus-low, or value), while the worst-performing funds have positive exposures. Negative exposures to factors that have premiums reduce returns earned by investors. The negative loadings resulted in these surprising results:
- An equal-weighted portfolio of all funds produced an average return of about 7% per year.
- The average annual return for the portfolio of the worst performers was only slightly less than average, at 6.8%.
- The average annual return for the portfolio of the best performers was essentially the same, at 6.9%.