Percentage of Active Fund Managers That Can Beat the Market Shrinking Rapidly

by: IndexUniverse

By Matthew Hougan

The percentage of active fund managers that can beat the market is shrinking rapidly.

There's a great article in today's New York Times by Mark Hulbert detailing a new research study titled "False Discoveries in Mutual fund Performance: Measuring Luck in Estimating Alphas."

The Times doesn't include a link, but you can download the full research study from the University of Pennsylvania here.

The research piece is written by Laurent Barras, Olivier Scaillet and Russ Wermers. It examines the historical performance of active fund managers and uses a statistical technique called the "False Discovery Rate" to suss out funds that beat the market out of "luck" from funds that beat the market out of real active manager skill.

One key finding relayed by Hulbert's is that the percentage of active managers beating the market is shrinking ... rapidly. If you had applied the False Discovery Rate in 1990, you would have found that 14.4% of all managers had genuine stock-picking abilities that allowed them to beat the market. But when you study managers in 2006, that number drops to just 0.6%!!!

The authors provide three potential explanations for this dip in performance: 1) high fees; 2) all the skilled active managers have been hired away to run hedge funds; 3) the market has become more efficient.

I don't agree with point #1, as managers in the 1990s also had to deal with fees. Point two is a possibility, given the huge growth in the hedge fund industry. But point number three seems like a real answer, given all the changes in the markets over the past 16 years: the rise of the Internet and real-time data; Regulation FD; etc.

Here's the lesson investors should draw from this: If you own an actively managed fund that has been beating the market, you probably ought to sell it before things revert to the mean. Chances are, your manager is no Peter Lynch. In fact, according to this study, Peter Lynch couldn't exist today.