Reassessing False Discoveries in Mutual Fund Performance: Skill, Luck, or Lack of Power?

33 Pages Posted: 26 Mar 2019

Date Written: March 3, 2019

Abstract

Barras, Scaillet, Wermers (2010) propose the False Discovery Rate to separate skill (alpha) from luck in fund performance. Using simulations with parameters informed by the data, we find that this methodology is overly conservative and underestimates the proportion of nonzero-alpha funds. E.g., 65% of funds with economically large alphas of ±2% are misclassified as zero-alpha. This bias arises from the low signal-to-noise ratio in fund returns and the consequent low statistical power. Our results raise concerns regarding the FDR’s applicability in performance evaluation and other domains with low power, and can materially change its conclusion that most funds have zero alpha.

Keywords: Mutual Funds, Skill, Performance, False Discovery Rate, Simulation

JEL Classification: G11, G23, C52, C58

Suggested Citation

Andrikogiannopoulou, Angie and Papakonstantinou, Filippos, Reassessing False Discoveries in Mutual Fund Performance: Skill, Luck, or Lack of Power? (March 3, 2019). Journal of Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3346034

Angie Andrikogiannopoulou

King's College London

Strand
London, WC2R 2LS
United Kingdom

Filippos Papakonstantinou (Contact Author)

King's College London ( email )

Strand
London, England WC2R 2LS
United Kingdom

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