Morningstar strategist Samuel Lee pointed to a study undertaken by Eugene Fama and Kenneth French entitled Luck Versus Skill in the Cross-Section of Mutual Fund Returns, which set out to determine what funds would look like if managers had no skill whatsoever.
Mr Lee said the study found that "if you had a crystal ball that could sort every equity mutual fund manager by true skill level, the top 16 per cent would be skilled enough to generate 1.25 per cent or greater outperformance over the long run, and the top 2 per cent would be able to generate 2.5 per cent outperformance – before fees".
He noted this finding is based on 'true skill' not historical outperformance, which is the "product of mostly luck over short periods".
"Once fees are taken into account, the evidence of skilled managers becomes even weaker," said Mr Lee. "One interpretation is [that] more skilled managers charge higher fees, extracting more of their outperformance."
Mr Lee said that while the study by Fama and French assumes excess returns arising from exposure to value and momentum stocks are attributable to risk rather than skills, using a more inclusive rubric that does not debit a manager’s performance for using such strategies indicates only the top 40 per cent of managers show evidence of skill before fees.
"After fees, the top 10 per cent of managers add value," he said.
Mr Lee argued this yardstick is not applicable today because value and momentum strategy index funds are "cheap and widely available".
"The hurdle for true alpha is now higher than it was 20 years ago, when value and momentum weren't widely known," he said.
Mr Lee said closet indexing could, however, be a mitigating factor to equity managers' "dismal collective performance".
Closet indexing obscures the true relationship between skill and luck, especially when looking at after-fee performance, he said.
"It's reasonable to believe that even skilled managers generate less outperformance on their lower-conviction ideas – perhaps even none," he said. "If this is the case, then closet indexing dilutes their ability to outperform."
Mr Lee said when managers index half of their portfolio, however, in effect they "double the fees on their active portfolios".
He added that while "all hope is not lost for the investor looking for skilled managers", the data suggests strong past performance is not sufficient to identify a skilled manager unless their record is exceptionally long.
