Jay D. Franklin

Morningstar's Manager of the Year: Luck or Skill?

Unfortunately for them, investors are constantly bombarded with advertisements, market commentaries, and screaming magazine covers telling them what they should do with their money. Contributing to all the clamor and din is Morningstar’s annual announcement of their awards for “Fund Manager of the Year.” As usual, investors are best served by not paying it any attention.

In order to determine whether being named “Fund Manager of the Year” engenders a valid expectation of higher returns for the fund’s investors, Index Funds Advisors ran a statistical test (the t-test) of sixteen domestic equity mutual funds which received this Morningstar recognition (cached article) to determine if the fund’s outperformance was truly attributable to skill (95% or higher probability) or if it could be explained as luck. For each fund, the performance from the manager’s inception date (or the inception date of Morningstar’s benchmark in two cases) through year-end 2011 was evaluated against the benchmark designated for the fund by Morningstar.  The charts below show each fund’s alpha (the difference in returns between the fund and the benchmark) on a year-by-year basis. Only one of the sixteen funds (about 6%) met the requirement of the statistical test that would suggest ruling out luck as the explanation for the outperformance based on a 95% confidence level. Before you get too excited however, please note that this fund belongs to the small growth category which of has the lowest expected return per unit of risk of all the different equity style boxes. Among the sixteen funds, the median number of years needed to conclude the presence of skill over luck was 72 years. Five of the funds showed a high enough degree of volatility in their returns (relative to their benchmarks) as to require a minimum of 100 years.

Even when there is a statistical indication of skill in a manager’s performance, it is often confined to a single time period and does not persist beyond it. A perfect example of this is Bill Miller of the Legg Mason Value Trust who carries the distinction of being the only mutual fund manager to have beaten the S&P 500 for fifteen consecutive years. Viewing the fifteen-year winning period alone indicates over a 99% probability of true skill, but if we broaden the scope of analysis to his entire tenure, we no longer can statistically conclude the presence of skill over luck.

Perhaps the first step to becoming a successful investor is acquiring the ability to tune out the “The Siren Songs of Active Management.” The Fund Manager of the Year is exactly such a song.

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