Are alphas just plain lucky?

In the stock market lexicon alpha represents the fund manager's unique stock picking ability. It is widely acknowledged that there are very few alpha fund managers, who consistently beat the market over a sustained period of time. However, what has come as a surpise is the findings of a study by Laurent Barras, Olivier Scaillet and Russ Wermers of about 2100 US mutual funds in the 1975-2006 period, that far from a small numbers of alpha managers, there actually may be none who beat the market consistently over a long period.

The study discounts for false positives (good luck) and false negatives (bad luck), by using a "False Discovery Rate" (FDR) method. Lucky funds have significant estimated alphas, while their true alphas are equal to zero. To address this issue, this paper quantified the impact of luck with new measures built on the FDR.

The study says,"Using a large cross-section of U.S. domestic-equity funds, we find that about one fifth of the funds in the population truly yield negative alphas. These funds are dispersed in the left tail of the alpha distribution. We also find a small proportion of funds with truly positive performance, which are concentrated in the extreme right tail of the alpha distribution."

With every passing year, the number of fund managers who pass the positive alpha tests decrease. If in 1990 (from 1975), there would have been 14.4% of fund managers had genuine stock picking ability, whereas the number had declined to a statistically indistinguishable 0.6%. Over smaller time frames, many fund managers beat the market.

The study attributes the reasons to the following
1. High fees and expenses. The researchers’ tests found that, on a pre-expense basis, 9.6% of mutual fund managers in 2006 showed genuine market-beating ability — far higher than the 0.6% 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.
2. Migration of good fund managers to hedge funds.
3. The market has become more efficient, thereby eliminating or trading away easy profit opportunities.

Hat tip: NYT