Measuring Skill in the Mutual Fund Industry∗

Using the dollar-value that a mutual fund adds as the measure of skill, we find that the average mutual fund adds about $2 million per year and that this skill persists for as long as 10 years. We further document that investors recognize this skill and reward it by investing more capital with better funds. Better funds earn higher aggregate fees, and there is a strong positive correlation between current compensation and future performance. ∗We could not have conducted this research without the help of the following research assistants to whom we are grateful: Ashraf El Gamal, Maxine Holland, Christine Kang, Fon Kulalert, Ian Linford, Binying Liu, Jin Ngai, Michael Nolop, William Vijverberg, and Christina Zhu. We thank George Chacko, Rick Green, Ralph Koijen, David Musto, Paul Pfleiderer, Anamaria Pieschacon, Robert Stambaugh and seminar participants at Robeco, Stockholm School of Economics, Stanford University, University of Chicago, University of Toronto, Vanderbilt, Wharton, the NBER summer institute, and the Stanford Berkeley joint seminar for helpful comments and suggestions. An important principle of economics is that agents earn economic rents if, and only if, they have a skill in short supply. As central as this principle is to microeconomics, surprisingly little empirical work has addressed the question of whether or not talent is actually rewarded, or, perhaps more interestingly, whether people without talent can earn rents. One notable exception is the research on mutual fund managers. There, an extensive literature in financial economics has focused on the question of whether stock picking or market timing talent exists. Interestingly, the literature has not been able to provide a definitive answer to this question. Considering that mutual fund managers are among the highest paid members of society, this lack of consensus is surprising because it leaves open the possibility that mutual fund managers earn economic rents without possessing a skill in short supply. Given the importance of the question, the objective of this paper is to re-examine whether or not mutual funds earn economic rents without possessing skill. We find that the average mutual fund adds value by extracting about $2 million a year from financial markets. More importantly, this value added is persistent. Funds that have added value in the past keep adding value in the future, for as long as 10 years. It is hard to reconcile our findings with anything other than the existence of money management skill. We find that the distribution of managerial talent is consistent with the predictions of Lucas (1978): higher skilled managers manage larger funds and reap higher rewards. One of our most surprising results is that investors appear to be able to identify talent and compensate it: current compensation predicts future performance. Our methodology differs from prior work in a number of important respects. First, our dataset includes all actively managed U.S. mutual funds, thereby greatly increasing the power of our tests. Prior work has used shorter time periods and focused attention exclusively on funds that only hold U.S. stocks. Second, in addition to evaluating managers using a risk model, we also evaluate managers by comparing their performance