False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas
Joint with: L. Barras, Geneva, and R.Wermers, Maryland
Standard testing approaches designed to identify funds with non-zero alphas do not account for the presence of lucky funds. Lucky funds have a significant estimated alpha,while their true alpha is equal to zero. This paper quantifies the impact of luck with new measures built on the False Discovery Rate (FDR). These FDR measures provide a simple way to compute the number and the proportion of funds with truly positive and negative performance in any portion of the tails of the cross-sectional alpha distribution. Using a large cross-section of U.S. domestic-equity funds, we find that 76.6% of them have zero alphas. 21.3% yield negative performance and are dispersed in the left tail of the alpha distribution. The remaining 2.1% with positive alphas are located at the extreme right tail. The same analysis is run on three investment categories (growth,aggressive growth, growth and income funds), as well as groups formed according to lagged fund characteristics (turnover, expense ratio, total net asset value).
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