Manager Skill—Active vs. Passive

Renowned financial economist Kenneth French shares his views on the difficulty of picking the next winning manager. Mark Hebner and Tom Cock discuss a chart titled, “Evidence of a Lack of Stock Picking Skill among Managers,” which analyzes the returns of 614 mutual funds. The results show that only one fund (0.16% of the funds) had a statistically significant positive alpha (which would determine skill over luck), but when the time period of the study was extended an additional two years, the statistical significance disappeared. Once again, the performance was due to luck, not skill.


“What Wall Street does is package luck and sell it as skill. The real data shows that passive management, actually in the last 20 years has achieved a greater return than active management.”

-- Dan Solin, retirement professional, best-selling author, Senior Vice President of Index Funds Advisors, Inc.

 

Long-term history and academic data strongly support a purely passive investment strategy.

The following bombshell study illuminates this fact:

"Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors analyzed 80,000 annual returns of institutional funds for the 23-year time period from 1984-2007 to conclude that 'much like individual investors who seem to switch mutual funds at the wrong time, institutional investors do not appear to create value from their investment decisions. In fact, the study estimates that over $170 billion was lost over the time period examined,' and that is before transaction costs and consultant fees are considered. The study concluded that plan sponsors could have saved hundreds of billions of dollars in assets if they had avoided manager selection based on recent performance and just stayed on course."

This study and dozens (if not hundreds) just like it arrive at similar conclusions that an optimal investment portfolio implementation is a risk-appropriate, low-cost and globally diversified index portfolio. IFA  recommends this strategy and provides online education to enable plan participants to identify the index portfolio that matches their risk capacity.


Sample Size Calculator for Active Manager Alphas

The calculator below shows the formula to calculate the number of years needed for a t-stat of 2. We first determine the excess return over a benchmark (the alpha), and then we determine the regularity of the excess returns by calculating the standard deviation of those returns. Based on these two numbers, we can then calculate how many years we need (sample size) to support the manager’s claim of skill.

Number of Years Needed for a Statistically Significant Alpha

Enter Average Excess Return (Alpha) and Standard Deviation of the Alpha to calculate for Number of Years Needed for t-stat of 2. A t-stat of 2 is needed to be 95% confident that the excess return (alpha) is not zero.


Average Excess Return (Alpha): 
 Standard Deviation of Alpha:  
 t-stat:
2
 
 Number of Years Needed for a t-stat of 2:

As you see in the calculator above, the t-stat is held at 2. Understanding why a t-stat of 2 or more is considered statistically significant is important. However, it is vital to simply grasp why higher t-stats mean the value is more “reliably” different from zero. To begin with, refer to the following equation defining a t-stat:

t-stat = (average x √Observations ) / standard deviation

Do you have index portfolios in your 401(k) Plan? To learn more about IFA’s Retirement Services offering, please call 888-643-3133.