Juhani T. Linnainmaa
University of Chicago Booth School of Business
“Mutual funds often disappear following poor performance. When this poor performance is partly attributable to negative idiosyncratic shocks, the fund’s estimated alpha understates its true alpha. This paper develops and estimates a structural model to evaluate this bias. I find that the bias in the mean of the observed alpha distribution is approximately 1 percent per year. When I correct for this bias using historical data, I find that the majority of fund managers still have negative net alphas but the average is not nearly as low as what the fund-level estimates suggest. This reverse survivorship bias affects all studies that run fund-level regressions to draw inferences about fund managers’ abilities.”
This paper is a critique of the prevailing notion that “you can’t argue with success.” Success is related to luck as well as to skill, in investment management as in anything else. When a fund does well in a short timeframe, it is not necessarily because it is well-managed. Conversely, when a fund does poorly in a short timeframe, it is not necessarily because it is poorly managed. The issue arises when investors use risk-adjusted returns to infer skill (or alpha).
Linnainmaa recognizes that when mutual funds disappear because of poor performance, sometimes failure is due to what he calls “negative idiosyncratic shocks,” or in layman’s terms, one-off bad-luck events. The fund manager might be skilled (i.e. have positive alpha) but the fund could still have poor returns. A subset of mutual funds which have disappeared probably have these characteristics.
The paper is actually a critique of “you can’t argue with failure.” There’s a tendency to point to failure as a direct indication of ability, and even character. Linnainmaa highlights the gap between truth and the truth we estimate from the data that is available to us.