Surprise: Some Active Managers are Skilled.

Surprise: Some Active Managers are Skilled.

June 19, 2015 $SPY, Yahoo Tickers

Last updated on August 20th, 2015 at 08:13 am

Print Friendly

Jonathan Berk, and his co-author Jules van Binsbergen, have a summary piece on a formal academic paper they published by the JFE in 2014. Here is a snippet:

Active fund managers are skilled and, on average, have used their skill to generate about $3.2 million per year. Large cross-sectional differences in skill persist for as long as ten years. Investors recognize this skill and reward it by investing more capital in funds managed by better managers. These funds earn higher aggregate fees, and a strong positive correlation exists between current compensation and future performance.

This is quite a bold claim, given the seemingly relentless attack on active management the past few years. However, this claim is coming from Jonathan Berk, who is not just another academic–this guy is the real deal. Prof. Jonathan Berk is a very well-known name in academic research circles.

One of his most famous papers, co-authored by Richard Green, is titled, “Mutual Fund Flows and Performance in Rational Markets.” The piece is a must read for anyone making an informed claim that active management is a complete waste of time. The Berk and Green paper made researchers rethink how they determine whether an investment manager’s performance record is due to skill or luck.

Before Berk and Green, researchers testing the efficient market hypothesis pointed towards the evidence that mutual fund manager performance has little persistence. Managers who do well in a specific year, don’t tend to achieve their same “skill” in future years. In other words, skill isn’t persistent. And of course, the “logical conclusion” from this research was that good performance is simply due to luck. Err…Wrong.

Assessing skill vs. luck is more complicated…

The “big” idea from Berk and Green is that some active managers do have skill, however, asset allocation markets are pretty efficient–the good managers get burdened with too much capital…but that doesn’t mean skilled managers don’t exist!

Consider a manager that can generate $1mm of “alpha” on a $10mm portfolio, or 10% alpha. This manager will quickly get more assets from allocators looking to capture some “edge.” This same skilled manager may be able to generate $10mm of “alpha” on $1B portfolio (i.e, 1% alpha). So this truly skilled manager will be quickly disregarded as “lucky” because their alpha goes from 10%/year to 1%/year, and 1%/year is hard to distinguish from dumb luck. Researchers that fail to account for this industry dynamic, conclude that skilled active management is not persistent, and therefore luck. An analogy is the research we recently highlighted on the “hot hand” in basketball. Research initially concluded that there was no such thing as a hot hand because shooters who got on a streak didn’t maintain their persistent streak. Of course, what happened is that defenders started closely guarding the streaky shooter–equivalent to dumping more assets on an asset manager–and the streaky shooter stopped looking so great. So the basketball player probably was on a streak–and would have continued that streak–but a new burden was placed on the hot-handed player and he was unable to continue being hot.

Here is a video of Prof. Berk explaining their insight into the skill vs. luck debate.


Note: This site provides no information on our value investing ETFs or our momentum investing ETFs. Please refer to this site.


Join thousands of other readers and subscribe to our blog.


Please remember that past performance is not an indicator of future results. Please read our full disclaimer. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.




About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.