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False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas

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Author Info
Laurent BARRAS () (HEC-University of Geneva and FAME)
Olivier SCAILLET () (HEC-University of Geneva and FAME)
Russ WERMERS () (University of Maryland, Robert H. Smith School of Business)

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Abstract

Standard tests designed to identify mutual funds with non-zero alphas are problematic, in that they do not adequately account for the presence of lucky funds. Lucky funds have significant estimated alphas, while their true alphas are equal to zero. To address this issue, this paper quantifies the impact of luck with new measures built on the False Discovery Rate (FDR). These FDR measures provide a simple way to compute the proportion of funds with genuine positive or negative performance as well as their location in the cross-sectional alpha distribution. Using a large cross-section of U.S. domestic-equity funds, we find that about one fifth of the funds in the population truly yield negative alphas. These funds are dispersed in the left tail of the alpha distribution. We also find a small proportion of funds with truly positive performance, which are concentrated in the extreme right tail of the alpha distribution.

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Publisher Info
Paper provided by International Center for Financial Asset Management and Engineering in its series FAME Research Paper Series with number rp163.

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Date of creation: Nov 2005
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Handle: RePEc:fam:rpseri:rp163

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Related research
Keywords: Mutual Fund Performance; False Discovery Rate; Multiple Testing;

Other versions of this item:

Find related papers by JEL classification:
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G23 - Financial Economics - - Financial Institutions and Services - - - Pension Funds; Other Private Financial Institutions
C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: General - - - Hypothesis Testing

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Grinblatt, Mark & Titman, Sheridan, 1993. "Performance Measurement without Benchmarks: An Examination of Mutual Fund Returns," Journal of Business, University of Chicago Press, vol. 66(1), pages 47-68, January. [Downloadable!] (restricted)
  2. Newey, Whitney K & West, Kenneth D, 1987. "A Simple, Positive Semi-definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix," Econometrica, Econometric Society, vol. 55(3), pages 703-08, May. [Downloadable!] (restricted)
    Other versions:
  3. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March. [Downloadable!] (restricted)
  4. Grinblatt, Mark & Titman, Sheridan D, 1989. "Mutual Fund Performance: An Analysis of Quarterly Portfolio Holdings," Journal of Business, University of Chicago Press, vol. 62(3), pages 393-416, July. [Downloadable!] (restricted)
    Other versions:
  5. Pastor, Lubos & Stambaugh, Robert F., 2002. "Investing in equity mutual funds," Journal of Financial Economics, Elsevier, vol. 63(3), pages 351-380, March. [Downloadable!] (restricted)
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  6. Elton, Edwin J & Gruber, Martin J & Blake, Christopher R, 1996. "The Persistence of Risk-Adjusted Mutual Fund Performance," Journal of Business, University of Chicago Press, vol. 69(2), pages 133-57, April. [Downloadable!] (restricted)
  7. Bruce N. Lehmann & David M. Modest, 1987. "Mutual Fund Performance Evaluation: A Comparison of Benchmarks and Benchmark Comparisons," NBER Working Papers 1721, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  8. Robert Kosowski & Allan Timmermann & Russ Wermers & Hal White, 2006. "Can Mutual Fund "Stars" Really Pick Stocks? New Evidence from a Bootstrap Analysis," Journal of Finance, American Finance Association, vol. 61(6), pages 2551-2595, December. [Downloadable!] (restricted)
  9. Daniel, Kent, et al, 1997. " Measuring Mutual Fund Performance with Characteristic-Based Benchmarks," Journal of Finance, American Finance Association, vol. 52(3), pages 1035-58, July. [Downloadable!] (restricted)
  10. Grinblatt, Mark & Titman, Sheridan & Wermers, Russ, 1995. "Momentum Investment Strategies, Portfolio Performance, and Herding: A Study of Mutual Fund Behavior," American Economic Review, American Economic Association, vol. 85(5), pages 1088-1105, December. [Downloadable!] (restricted)
  11. Elton, Edwin J, et al, 1993. "Efficiency with Costly Information: A Reinterpretation of Evidence from Managed Portfolios," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 6(1), pages 1-22. [Downloadable!] (restricted)
  12. Lehmann, Bruce N & Modest, David M, 1987. " Mutual Fund Performance Evaluation: A Comparison of Benchmarks and Benchmark Comparisons," Journal of Finance, American Finance Association, vol. 42(2), pages 233-65, June. [Downloadable!] (restricted)
  13. Chen, Hsiu-Lang & Jegadeesh, Narasimhan & Wermers, Russ, 2000. "The Value of Active Mutual Fund Management: An Examination of the Stockholdings and Trades of Fund Managers," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 35(03), pages 343-368, September. [Downloadable!]
  14. John D. Storey, 2002. "A direct approach to false discovery rates," Journal Of The Royal Statistical Society Series B, Royal Statistical Society, vol. 64(3), pages 479-498. [Downloadable!] (restricted)
  15. Ferson, Wayne E & Schadt, Rudi W, 1996. " Measuring Fund Strategy and Performance in Changing Economic Conditions," Journal of Finance, American Finance Association, vol. 51(2), pages 425-61, June. [Downloadable!] (restricted)
  16. Fama, Eugene F & French, Kenneth R, 1996. " Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance, American Finance Association, vol. 51(1), pages 55-84, March. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Edward Tower & Wei Zheng, 2008. "Ranking mutual fund families: minimum expenses and maximum loads as markers for moral turpitude," International Review of Economics, Springer, vol. 55(4), pages 315-350, December. [Downloadable!] (restricted)
  2. Oussama Chakroun & Georges Dionne & Amélie Dugas-Sampara, 2006. "Empirical Evaluation of Investor Rationality in the Asset Allocation Puzzle," Cahiers de recherche 0635, CIRPEE. [Downloadable!]
  3. Anthony Tay & Jacques Olivier, 2008. "Time-Varying Incentives in the Mutual Fund Industry," Working Papers 10-2008, Singapore Management University, School of Economics, revised Jun 2008. [Downloadable!]
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