Last Updated May 10, 2010 10:44 AM EDT
Bradford Cornell of the California Institute of Technology contributed to the literature with his study "Luck, Skill and Investment Performance."Cornell noted that the distinction between skill and luck is important for making investment decisions: "An investment manager who is skillful this year presumably will be skillful next year. An investment manager who was lucky this year is no more likely to be lucky next year than any other manager. The problem is that skill and luck are not independently observable."
Since skill and luck are not directly observable, we're left with observing performance. Cornell used Morningstar's 2004 database of mutual fund performance to analyze 1,034 funds that invest in large-cap value funds. Cornell's findings are consistent with previous researchÂ -- the great majority (92 percent) of the cross-sectional variation in fund performance is due to random noise. This result demonstrates that "most of the annual variation in performance is due to luck, not skill." He concluded: "The analysis also provides further support for the view that annual rankings of fund performance provide almost no information regarding management skill."
Professors Eugene Fama and Ken French also studied this topic in their paper "Luck versus Skill in the Cross Section of Mutual Fund Returns." Using statistical analysis, they found that active managers as a group haven't added any value over appropriate passive benchmarks. They concluded: "For (active) fund investors the simulation results are disheartening." They did concede that the results look better when looking at gross returns -- the returns without the expense ratio included. However, gross returns are irrelevant unless you can find an active manager willing to work for free.
The Efficient Market Hypothesis tells us it's only by random luck that a fund is able to persistently outperform after the expenses of its efforts. The evidence from the two aforementioned studies provides support for this hypothesis.
The choice is yours. You could try to beat overwhelming odds and attempt to find one of the few mutual funds that will deliver future outperformance. Or you could capture the returns the market provides by investing passively. The academic research demonstrates that investing in passively managed funds is the superior strategy. Such high odds against winning is why Charles Ellis called active management the "loser's game."