Your favourite hedge fund manager has walloped the market by 5% per year for the past 10 years, so he’s obviously a genius, right?
Actually, no. He had a one-in-five chance of doing that just by throwing darts.
Here’s professor Ken French of Tuck, an advisor to Dimensional Fund Advisors, on the ease of mistaking luck for skill in investing:
People often misinterpret high average fund returns as proof that a manager does know how to identify pricing errors. Consider, for example, a hedge fund with an annual volatility of 20%. (To be more precise, the standard deviation of the fund’s excess return with respect to the appropriate benchmark is 20%.) If the fund’s average abnormal return is 5% per year over a 10-year period, many investors and financial reporters would conclude that the manager is truly gifted, with a real knack for identifying under- and over-valued securities. But they would probably be wrong.
Suppose the manager’s true alpha is zero, so he really has no skill beyond that needed to recover his costs. If we pretend his returns are normally distributed, the probability that his average abnormal return exceeds 5% per year for a 10 year period is more than 20%.
In other words, in a group of hedge fund managers with standard deviations of 20%, we expect one in five to have a 10-year average annual abnormal return of at least 5%—even if none actually have any skill. We expect one in 20 of the unskilled managers to produce a 10-year average annual abnormal return of at least 10%.
But by all means go ahead and explain why YOUR favourite hedge fund manager with an impressive track record actually has skill.
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