Strategies - The Prescient Are Few - NYTimes.com 





July 13, 2008
Strategies
The Prescient Are Few 
By MARK HLBERT
HOW many mutual fund managers can consistently pick stocks that outperform the 
broad stock market averages — as opposed to just being lucky now and then? 
Countless studies have addressed this question, and have concluded that very few 
managers have the ability to beat the market over the long term. Nevertheless, 
researchers have been unable to agree on how small that minority really is, and 
on whether it makes sense for investors to try to beat the market by buying 
shares of actively managed mutual funds.
A new study builds on this research by applying a sensitive statistical test 
borrowed from outside the investment world. It comes to a rather sad conclusion: 
There was once a small number of fund managers with genuine market-beating 
abilities, as judged by having past performance so good that their records could 
not be attributed to luck alone. But virtually none remain today. Index funds 
are the only rational alternative for almost all mutual fund investors, 
according to the study’s findings.
The study, “False Discoveries in Mutual Fund Performance: Measuring Luck in 
Estimating Alphas,” has been circulating for over a year in academic circles. 
Its authors are Laurent Barras, a visiting researcher at Imperial College’s 
Tanaka Business School in London; Olivier Scaillet, a professor of financial 
econometrics at the University of Geneva and the Swiss Finance Institute; and 
Russ Wermers, a finance professor at the University of Maryland. 
The statistical test featured in the study is known as the “False Discovery 
Rate,” and is used in fields as diverse as computational biology and astronomy. 
In effect, the method is designed to simultaneously avoid false positives and 
false negatives — in other words, conclusions that something is statistically 
significant when it is entirely random, and the reverse.
Both of those problems have plagued previous studies of mutual funds, Professor 
Wermers said. The researchers applied the method to a database of actively 
managed domestic equity mutual funds from the beginning of 1975 through 2006. To 
ensure that their results were not biased by excluding funds that have gone out 
of business over the years, they included both active and defunct funds. They 
excluded any fund with less than five years of performance history. All told, 
the database contained almost 2,100 funds.
The researchers found a marked decline over the last two decades in the number 
of fund managers able to pass the False Discovery Rate test. If they had focused 
only on managers running funds in 1990 and their records through that year, for 
example, the researchers would have concluded that 14.4 percent of managers had 
genuine stock-picking ability. But when analyzing their entire fund sample, with 
records through 2006, this proportion was just 0.6 percent — statistically 
indistinguishable from zero, according to the researchers.
This doesn’t mean that no mutual funds have beaten the market in recent years, 
Professor Wermers said. Some have done so repeatedly over periods as short as a 
year or two. But, he added, “the number of funds that have beaten the market 
over their entire histories is so small that the False Discovery Rate test can’t 
eliminate the possibility that the few that did were merely false positives” — 
just lucky, in other words.
Professor Wermers says he was surprised by how rare stock-picking skill has 
become. He had “generally been positive about the existence of fund manager 
ability,” he said, but these new results have been a “real shocker.” 
WHY the decline? Professor Wermers says he and his co-authors suspect various 
causes. One is high fees and expenses. The researchers’ tests found that, on a 
pre-expense basis, 9.6 percent of mutual fund managers in 2006 showed genuine 
market-beating ability — far higher than the 0.6 percent after expenses were 
taken into account. This suggests that one in 10 managers may still have 
market-beating ability. It’s just that they can’t come out ahead after all their 
funds’ fees and expenses are paid.
Another possible factor is that many skilled managers have gone to the hedge 
fund world. Yet a third potential reason is that the market has become more 
efficient, so it’s harder to identify undervalued or overvalued stocks. Whatever 
the causes, the investment implications of the study are the same: buy and hold 
an index fund benchmarked to the broad stock market. 
Professor Wermers says his advice has evolved significantly as a result of this 
study. Until now, he says, he wouldn’t have tried to discourage a sophisticated 
investor from trying to pick a mutual fund that would outperform the market. 
Now, he says, “it seems almost hopeless.” 
Mark Hulbert is editor of The Hulbert Financial Digest, a service of 
MarketWatch. E-mail: strategy@nytimes.com.


Home 
  World U.S. N.Y. / Region Business Technology Science Health Sports Opinion 
  Arts Style Travel Jobs Real Estate Automobiles Back to Top 
Copyright 2008 The New York Times Company 
  Privacy Policy Search Corrections RSS First Look Help Contact Us Work for Us 
  Site Map