Surprise: Some Active Managers are Skilled.

/Surprise: Some Active Managers are Skilled.

Surprise: Some Active Managers are Skilled.

By | 2017-08-18T16:56:33+00:00 June 19th, 2015|$SPY, Yahoo Tickers|4 Comments

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.

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About the Author:

Wes Gray
After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes,, and the CFA Institute. 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.
  • IlyaKipnis

    This is actually a fantastic point. Something that no backtest can intrinsically take into account is the issue of capacity. Because thanks to capacity, what would be amazing instruments for diversification now have nowhere near enough capacity to support your superior alpha strategy.

  • Ryan

    His argument is essentially that managers who outperform can raise their fees (either by increasing their fee or charging on more assets) until they market perform.

    All value created by managers is therefore captured by their fee, leaving the investors with no excess return.

  • Michael Milburn

    There’s hope for us all! 😉

    It’s interesting in the recent interview w/ Jim Simons (somewhere on youtube) he talks about the importance of understanding and modeling a strategy’s impact on the overall market price. To me it implies there are strategies that work, but with variably vanishing degrees of scalability.

  • Clay Jennings

    This paper and its conclusions suffer from many flaws. Most notably, a complete lack of empirical support for the notion that size impacts performance negatively. By how much? At what point with increasing assets? In what capital markets? It takes this vague notion, widely accepted in general by most market observers and practitioners, and takes it fully for granted and uses it as a generic baseline for all its resulting claims. Ridiculous. There may in fact be manager skill, but finding it in advance after adjusting for fees is a fool’s errand. Markets will continue to confound smart and less smart investors alike, be they professional or not. There is no shortage of “smart” in the markets. They are the market!