EFF: In an interview with Client Insights host Dan Richards, I explain the key findings of the paper "Luck vs. Skill in Mutual Fund Performance" that Ken French and I published in 2010. Looking at funds over their entire lifetimes, only 3% demonstrate skill after accounting for their fees, and that's what you would expect purely based on chance. Even the active funds that have generated extraordinary returns are unlikely to do better than a low-cost passive fund in the future.See also: our 2008 post, "Gaming the System: Are Hedge Fund Managers Talented, or Just Good at Fooling Investors?":
It's easy for an unscrupulous hedge fund manager to make himself look better than he is, as Foster and Young demonstrate in their paper. "We show, in particular, that managers can mimic exceptional performance records with high probability (and thereby earn large fees) without delivering exceptional performance."An investment pool's returns come in two parts: beta, which is merely riding the coattails of a rising market, and alpha, the extra return produced by smart investment choices. Because hedge funds use leverage, or borrowed money, and invest in derivatives, it is fairly easy to produce "fake alpha," the researchers say....