Active Sector Funds and Fund Manager Skill

The authors investigate the performance of active sector funds whose potential outperformancehas not been exhausted entirely by decreasing returns to scale. The authors document thatdespite good track records, most sector funds are relatively smaller than their equilibriumfund sizes — at which they are expected to generate zero net alphas. In particular, from1998 to 2016, a passive indexation strategy of actively managed sector funds earns an annualbenchmark-adjusted return of 5.70% and a monthly alpha of 27 basis points. Moreover, thestrategy's outperformance is present in market downturns (i.e., resilient to tail risk) and robustto change of rebalancing frequency and inclusion of expenses. Efficient diversification andunder-appreciated skill – illustrated by an alpha-arithmetic to guide similar strategies – explainthe strategy's success