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

Author

Listed:
  • Laurent BARRAS

    (Imperial College, Tanaka Business School and Swiss Finance Institute)

  • Olivier SCAILLET

    (University of Geneva (HEC), Swiss Finance Institute)

  • Russ WERMERS

    (University of Maryland, Robert H. Smith School of Business)

Abstract

This paper develops a simple technique that properly controls for “false discoveries,” or mutual funds that exhibit significant alphas by luck alone, to evaluate the performance of actively managed U.S. domestic-equity mutual funds during the 1975 to 2006 period. Our approach precisely separates mutual funds into those having (1) unskilled, (2) zeroalpha, and (3) skilled fund managers, net of expenses, even with cross-fund dependencies in estimated alphas. This separation into skill groups allows several new insights. First, we find that the majority of funds (75.4%) pick stocks well enough to cover their trading costs and other expenses, producing a zero alpha, consistent with the equilibrium model of Berk and Green (2004). Further, we find a significant proportion of skilled (positive alpha) funds prior to 1996, but almost none by 2006, accompanied by a large increase in unskilled (negative alpha) fund managers—due both to a large reduction in the proportion of fund managers with stockpicking skills and to a persistent level of expenses that exceed the value generated by these managers. Finally, we show that controlling for false discoveries substantially improves the ability to find funds with persistent performance.

Suggested Citation

  • Laurent BARRAS & Olivier SCAILLET & Russ WERMERS, 2005. "False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas," Swiss Finance Institute Research Paper Series 08-18, Swiss Finance Institute, revised Sep 2008.
  • Handle: RePEc:chf:rpseri:rp0818
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    References listed on IDEAS

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    Keywords

    Mutual Fund Performance; Multiple-Hypothesis Test; Luck; False Discovery Rate;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General

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