Measuring Managerial Skill in the Mutual Fund Industry

Measuring Managerial Skill in the Mutual Fund Industry

Jonathan B. Berk

Stanford University and NBER

Jules H. van Binsbergen

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Stanford University and NBER

November 4, 2013


Using the value that a mutual fund extracts from capital markets as the measure of skill, we find that the average mutual fund has used this skill to generate about $2 million per year. We document large cross-sectional differences in skill that persist for as long as 10 years. We further document that investors recognize this skill and reward it by investing more capital with better funds. Better funds earn higher aggregate fees, and there is a strong positive correlation between current compensation and future performance. We also demonstrate why traditional measures such as the gross and net alpha fail to measure managerial skill which explains why past studies that use those measures have failed to find evidence of this skill.

Measuring Managerial Skill in the Mutual Fund Industry

An important principle of economics is that agents earn economic rents if, and only if, they have a competitive advantage that is in short supply. As central as this principle is to microeconomics, surprisingly little empirical work has addressed the question of whether or not such talent is actually rewarded, or, perhaps more interestingly, whether people without such talent can earn rents. One notable exception is the research on mutual fund managers. There, an extensive literature in financial economics has focused on the question of whether stock picking or market timing talent exists. Interestingly, the literature has not been able to provide a definitive answer to this question. Considering that mutual fund managers are among the highest paid members of society, this lack of consensus is surprising because it leaves open the possibility that mutual fund managers earn economic rents without possessing a skill in short supply.

Given the importance of the question, the objective of this paper is to re-examine whether or not mutual funds earn economic rents without possessing skill. We find that the average mutual fund has added value by extracting about $2 million a year from financial markets. Most importantly, cross sectional differences in value added are persistent for as long as 10 years. It is hard to reconcile our findings with anything other than the existence of money management skill. We find that the cross sectional distribution of managerial talent is consistent with the predictions of Lucas (1978): higher skilled managers manage larger funds and reap higher rewards. One of our most surprising results is that investors appear to be able to identify talent and compensate it: current compensation predicts future performance.

Many prior studies have used the net alpha to investors, i.e., the average abnormal return net of fees and expenses, to assess whether or not managers have skill.1 However, as Berk and Green (2004) argue, if skill is in short supply, the net alpha is determined in equilibrium by competition between investors, and not by the skill of managers. The net alpha measures the abnormal return offered to investors in the fund. It does not measure the skill of the manager of that fund.

Some people have hypothesized, based on this insight, that the gross alpha (the average abnormal return before fees are subtracted) would be the correct measure of managerial skill. However, the gross alpha is a return measure, not a value measure and so the gross alpha alone does not measure managerial skill. A manager who adds a gross alpha of 1% on a $10 billion fund adds more value than a manager who adds a gross alpha of 10% on a $1 million fund. In fact, under the neoclassical assumptions that managers optimize, markets are competitive and investors rational, the only condition under which the gross alpha will reliably differentiate managers is if all funds are exactly the same size.

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