Examining the Presence of Luck and Skill in Mutual Fund Returns

By Joe Matten. Stanford University. 

I wrote the following essay for Professor Shoven’s class, “A Random Walk Down Wall Street.” Inspired by Burton Malkiel’s book of the same name, the class featured discussions of the major topics and themes of the work—one such theme being whether or not discernable skill exists in actively managed mutual funds. Quite surprising to me was the book’s insistence that actively managed mutual funds under- perform passive benchmarks, and even were skill to exist, it would not be discernable from luck to an investor. In my paper, I try to explain why actively managed mutual funds underperform passive benchmarks, and I include research demonstrating evidence for both sides of the argument for the presence of skill in actively managed funds. First, I present William Sharpe’s logical argument for why these active funds must underperform passive funds. Next, I provide a literature review detailing some facets of the research into the persistence of mutual fund returns. I conclude by offering a more in-depth look into the seminal 2010 Fama and French paper that compares the true alpha of actively managed mutual funds to a cloned population where skill has been statistically removed.

Read the full paper here.