Not Fooled by Randomness: Using Random Portfolios to Analyze Investment Funds
Roberto Andres Stein
University of Nebraska at Lincoln - Department of Finance
August 31, 2012
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
Date posted: September 8, 2012