Reassessing False Discoveries in Mutual Fund Performance: Skill, Luck, or Lack of Power?
33 Pages Posted: 26 Mar 2019
Date Written: March 3, 2019
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: Suggested Citation