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M utual fund alpha is a well-known indicator for manager skill. Numerous studies have been published on whether fund alpha exists and whether it can serve as a reliable measure for manager skill. In the literature, some researchers have documented statistically significant alpha, whereas others have found that several common risk factors can explain alpha completely. Some researchers found that alpha comes from manager skill, whereas others concluded that it is simply pure luck.
Despite the abundant literature on this topic, no consensus has been reached yet. Henriksson [1984], Fama and French [1993], Malkiel [1995, 2013], and Jiang [2003] concluded that no funds can beat the market consistently. Carhart [1997] showed that four market factors can explain the persistence in funds' mean and risk-adjusted returns. Sharpe [1991] found that active investing is always a negative sum game. French [2008] found that investors would increase their average annual return by 67 basis points by adopting a passive investment strategy. Moreover, Smith and Walsh [2013] argued that it is very difficult to beat the market using publicly available information and thus the market is still efficient.
On the other hand, Grinold and Kahn [1999] concluded that fund managers can construct portfolios that consistently beat the market using forecasts derived from the raw signals of asset returns. Ibbotson and Patel [2002] concluded that fund superior performance is repeated even after adjusting for investment style, and Ding and Wermers [2005] reported outperformance both for large-fund and small-fund managers. Avramov and Wermers [2006]; Kacperczyk, Sialm, and Zheng [2005]; Cuthbertson, Nitzsche, and O'Sullivan [2008, 2012]; and Bird, Pellizzari, and Yeung [2015] concluded that manager skills do exist and are the main source of profitability. In addition, Brown [2012] found that managing operation risk through operational due diligence is a source of mutual fund alpha. Furthermore, Berk and Binsbergen [2012] concluded that skill exists and is persistent as far out as 10 years.
Ding and Wermers [2005] found that experienced large-fund managers can outperform the market. Kosowski et al. [2006] used a bootstrapping test to examine the performance of U.S. equity mutual funds. They found that a small group of fund managers can earn statistically significant alpha and that the superior alphas of these managers persist. In light of the findings of...