Where Has All the Alpha Gone?

The small group of money mangers who possessed the ability to outperform the market has virtually disappeared, according to a new study.

Throughout the study – titled “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimating Alphas” – the co-authors used a statistical test called the “False Discovery Rate” to measure money managers’ capabilities in reading the market.

This test differs from traditional fund management research by avoiding all false positives and false negatives, affecting outcomes of earlier studies. The research showed that the number of fund managers able to pass the False Discovery Rate test had decreased to .6%, a number that is statistically indistinguishable from 0.

The authors of this study – Laurent Barras, a visiting researcher at Imperial College's Tanaka Business School in London; Russ Wermers, a financial professor at the University of Maryland; and Olivier Scaillet, a financial econometrics professor at the University of Geneva and the Swiss Finance Institute – attribute this decline to the expenses and fees of money managed funds, the rise of hedge funds and the leveling of the market.

In 2006, it was found that 1 in 10 managers had the ability to beat the market, but after taking fees and expenses into account, the average fell back to .6%.

Many skilled managers have moved to the hedge fund industry which has grown in size, popularity and value in recent years.

The authors say the market has become more efficient, making it harder for money managers to select undervalued and overvalued stocks.

The study and the authors conclude that indexed funds are the most rational investment alternative for mutual fund investors.

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