Does the systematic outperformance of fund managers relative to their benchmark over a long enough period reflect skill or luck? This is a debate that has been raging on ever since the proponents of the efficient market hypothesis entered the scene. If even the weak form of the efficient market hypothesis holds true, most of the outperformance could very well be attributed to just plain luck. The reasoning goes something like this: at a micro level, even if a gifted manager is able to identify industry trends, it is impossible to anticipate powerful random events such as unanticipated changes in government regulation or even natural events. In other words, there is a significant random component that can creep into and distort the earnings of a company.
This isn’t to say that skill doesn't play any role, it certainly does but the danger is that actual skill may be overestimated. Take the following example:
A hundred people are invited into a hall and asked to perform the simple task of flipping a coin. Those that obtain “tails” are kindly asked to leave the hall whilst the remaining persons are asked to repeat the coin flipping exercise. This experiment is continued until one person, the winner, is left. In terms of statistics, the probability of obtaining “heads” is 50%. Each draw is independent from the other, which means that the probability for each draw are not influenced by any other draw. Taking this into consideration, we can expect about 50 persons leaving the hall after the first draw, another 25 after the second and about 12 after the third etc. After about 6 draws there should remain only one person. Now if we forget about this experiment and try to visualize these results in terms of the performance of a particular fund manager, we could easily get carried away into thinking it was due to skill. As the experiment has shown us, the exceptional results could be a result of just plain old luck but the observers are totally blind to this. They are much likely to attribute the way better than average results to the manager's particular skills. That particular manager will be revered and a large amount of money will flow into the fund but if the results were more luck than skill, it will turn out to be a very bad investment.
