15-Apr-2006
Hal White and Friends, by Philip J. McDonnell

Kim Zussman brought us yet another interesting study:

Excerpts:

(We) Use bootstrap procedures to show that some high-alpha mutual funds have persistent out-performance, especially in growth fund:

We test whether the estimated four-factor alphas of "star" mutual fund managers are due solely to luck or, at least in part, to genuine stockpicking skills.

After reading the study it is not clear that the entire conclusion is warranted. The figures shown as the bootstrap alpha t-statistic in Table VII on p. 49 seem to indicate that only the top fund each year may show significant alpha. On the other hand the bottom deciles 6 through decile 10 generally show statistically significant negative alpha.

The point is that the methodology of the study is very good at picking out inferior performance by what appears to be about one half of the mutual fund industry (!) but not very effective at identifying top performing funds, with the possible exception of the single top fund itself.

The reasons that half the funds under-perform are probably two fold. First, some may be proactively incompetent money managers to the extent that they are non-randomly picking bad stocks and exhibit poor market timing. Secondly, some may be crooks and are simply robbing their investors in one way or another. In some cases both factors may be at work.

In any event it appears to me that the four factor methodology employed in the study cannot reliably pick a good performing fund, but it can help one avoid the entire bottom half of the spectrum. On the other hand it may be a good model for regulators who wish to weed out the crooks from the majority of legitimate funds.

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