Skill vs. Luck in Mutual Fund Performance

Let’s imagine a hypothetical group of 1,024 actively-managed funds. If we look at pre-expense results, roughly 50% of the funds should outperform the market each year. That means that after 7 years,

8 of the funds will have outperformed the market every year,
64 funds will have outperformed the market in at least 6/7 years, and
232 funds will have outperformed the market in at least 5/7 years.

And that’s based purely on luck. No need for any fund management skill at all.

According to the Investment Company Institute, at the beginning of 2002, there were 4,756 equity mutual funds. Using our numbers from above, we can see that pure luck would account for 1,077 different funds outperforming the market in at least 5 of the last 7 years on a pre-expense basis. There would even be 37 funds that would have outperformed in each of the last 7 years.

And yet, I suspect that most of us are inclined to think “wow, this guy is good!” when we see a fund with a record of beating the market for each of the last 7 years. Oops.

The simple fact that a fund manager has outperformed the relevant benchmark index doesn’t tell us very much at all.

What about extended periods of outperformance?

According to Jeremy Siegel (in Stocks for the Long Run), in order to be able to say with 95% confidence that a fund manager’s performance is due to skill rather than luck, he’d need to outperform the market by an average of 4% per year for roughly 15 years. (If the fund was only outperforming by 3% annually, it would take more than 20 years.)

The problem, however, is that by the time we’ve seen a fund manager outperform the market for 15 years in a row, it’s not particularly likely that he (or she) will be managing the fund for much longer.

So how should we choose funds then?

Of course, picking an actively-managed fund with a long-term record of outperformance is probably better than picking an actively-managed fund with a long-term record of underperformance. But don’t fall into the trap of assuming that a fund manager must be a genious simply because he’s beaten the market for the last several years.

Rather than focusing exclusively on past performance when choosing mutual funds, try doing the following: