Active Sector Funds and Fund Manager Skill

The authors investigate the performance of active sector funds whose potential outperformance has not been exhausted entirely by decreasing returns to scale. The authors document that despite good track records, most sector funds are relatively smaller than their equilibrium fund sizes, at which they are expected to generate zero net alphas. In particular, from 1998 to 2016, a passive indexation strategy of actively managed sector funds earns an annual benchmark-adjusted return of 5.70% and a monthly alpha of 27 bps. Moreover, the strategy's outperformance is present in market downturns (i.e., resilient to tail risk) and robust to change of rebalancing frequency and inclusion of expenses. Efficient diversification and underappreciated skill, illustrated by an alpha-arithmetic to guide similar strategies, explain the strategy's success.