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

This paper uses a new approach to determine the fraction of truly skilled managers among the universe of U.S. domestic-equity mutual funds over the 1975 to 2006 period. We develop a simple technique that properly accounts for “false discoveries,” or mutual funds which exhibit significant alphas by luck alone. We use this technique to precisely separate actively managed funds into those having (1) unskilled, (2) zero-alpha, 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 1995, 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.