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Investors may choose a passive fund because they don’t believe they can distinguish between luck and skill among active fund managers. But new research shows that the issue of luck and skill plays an important role in passive fund returns too.

One of the great challenges for investors is distinguishing between luck (which is random) and skill (which persists) when evaluating performance. While it is easy to identify past alpha generators (outperformance on a risk-adjusted basis), the challenge is finding future alpha generators. One problem is that, given the large number of active funds, it is hard to distinguish skill from luck – even if no fund manager is good or bad, many funds will do well and many will do poorly purely by chance. In other words, when you examine fund-by-fund performance, you need to determine whether the range of outcomes is wider than expected by chance. If that is the case, you can infer that there are bad fund managers overpopulating the left tail of outcomes and good managers overpopulating the right tail.

The authors of studies such as, “Luck, Skill, and Investment Performance,” “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” “Conviction in Equity Investing” and “Luck vs. Skill Across Different Fund Categories” have found that it is very difficult to distinguish between luck and skill. And the study, “Scale and Skill in Active Management,” found that this is true even though the authors found evidence of increasing skill among fund managers. That is why the SEC requires the disclaimer that past performance is not a guarantee of future performance, and The American Law Institute, in its Third Restatement of Trusts, concluded: “Evidence shows that there is little correlation between a fund manager’s past successes and their ability to produce above-market returns in subsequent periods.”