Mutual Fund Performance: Luck or Skill?

Should individuals include actively managed mutual funds in their investment portfolios? They should if and only if the result of active management is superior performance due to skill. This paper employs a previously ignored statistical technique to detect whether skill drives the superior performance of some mutual funds. This technique, the generalized binomial distribution, models a sequence of n Bernoulli events in which the result of each event is either success or failure (successive quarters during which funds outperform or do not outperform the market). Results display a statistically significant proportion of mutual funds, though small in number, outperform their peers on a risk-adjusted basis and do so as a result of skill, not luck. This result signifies the rationality of entrusting one's wealth to successful and skillfully managed mutual funds. Hence, a well-designed portfolio that includes actively managed funds may trump a wholly passive index fund strategy.