Not Fooled by Randomness: Using Random Portfolios to Analyze Investment Funds

Posted: 8 Sep 2012  

Roberto Andres Stein

University of Nebraska at Lincoln - Department of Finance

Date Written: August 31, 2012

Abstract

The biggest challenge in testing mutual funds for manager skill is the lack of a probability distribution of returns under the null hypothesis of no skill. A methodology based on randomly trading portfolios and non parametric statistical tests is explored, and a test of skill is proposed. Simulation is used to perform an in-depth study of the properties of this test, and to compare its power against that of other tests of skill based on factor model alphas. Empirical tests performed on a sample of US equity mutual funds find evidence of skill in a reduced number of managers, but that the value added by this skill is charged away from the investors in the form of fund fees and expenses. Overall, random portfolio based measures are found to be more powerful and easier to interpret than tests based on traditional and bootstrapped factor model alphas.

Keywords: Mutual Fund Management, Luck, Skill, Factor Models, Non parametric measures

JEL Classification: C12, C14, G11, G23

Suggested Citation

Stein, Roberto Andres, Not Fooled by Randomness: Using Random Portfolios to Analyze Investment Funds (August 31, 2012). Available at SSRN: https://ssrn.com/abstract=2143293 or http://dx.doi.org/10.2139/ssrn.2143293

Roberto Andres Stein (Contact Author)

University of Nebraska at Lincoln - Department of Finance ( email )

Lincoln, NE 68588-0490
United States

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