July 28, 2014

What’s better than real world stock picking performance? A world with no investment skill….

No, the title doesn’t have a typo. The results of a recent S&P Dow Jones Indices study profiled in a New York Times article found that only 2 out of 2,862 (or 0.07%) broad domestic stock funds performed in the top quartile of funds over five consecutive twelve month periods ending March 2014.

As poor as that obviously is for active manager performance, an interesting question arises as to what the likelihood of outperformance would be if it was known to be a result of random chance.

The result…random chance (i.e. no investment skill) will generate outperformance more often than real world active managers.

It works like this. Assume that the chance of being in the top 25% of performance is equivalent to flipping heads twice in a row. Flip a head once and you are in the top 50%, flip heads again and now you are in the top 25%. So what is the chance of flipping consecutive heads five times in a row?

0.098%, 0.028% higher than the real world rate of domestic active stock fund outperformance.