Consider said paper, available here (at 6 pages it is a very easy read):http://faculty.chicagobooth.edu/john.co ... k_myth.pdf
The crux of the paper is that manager skill exists, but it is arbitraged away by the size of assets under management. So if a manager is skilled, investors will transfer more and more money to her management, to the point that her skill is offset by the difficulty in managing large amounts of assets (impact costs etc.) back to the benchmark level. This model explains why investors chase past returns - they are trying to exploit the skill of the manager, but it is arbitraged away when everyone tries to do it. Past returns reflect skill
, not returns, since the latter are affected by the amount of assets under management. Skill could then be defined as the ability to generate alpha for a given amount of assets
The paper and the model it suggests are very interesting, but I don't see how they explains the following scenario. Suppose John is a very talented active manager, he's running a small fund and generates significant alpha for a few years. According to the model, a lot of money is transferred to his fund, until he can no longer generate alpha. So far so good. Now suppose John is fired as he is no longer able to generate alpha, and he goes to work for a small fund again. According to the model, so long as the fund remains small, he should be able to generate alpha.
I have a couple of problems with that:
1. To the best of my knowledge, manager
performance doesn't persist, regardless of the size of the fund.
2. As far as I know, investors generally chase past fund
returns, not manager returns. So supposedly there is an inefficiency and opportunity for profit here by investing in John's new small fund, until the market realizes that the fund is outperforming (due to its skilled manager). Under the paper's model, I'd expect investors to chase individual managers rather than funds in an efficient market.
3. A fund manager could quit the game and simply invest his own money, supposedly outperforming the market persistently since the amount of money he personally has is much lower than the amount that would impair his skill. Again, individual investors aren't known to beat the market persistently so this doesn't make sense. One could claim, though, that once the manager no longer has the resources of the fund, his skill decreases.
The only way I can explain the above is if skill (or more precisely, skill relative to other managers), can change over time. A manager could gain experience and become better, he could gain too much confidence and become worse, newcomer wildcard managers could join the game and change the picture, old managers could quit, the game itself could change thereby altering the factors that constitute skill (e.g. the advent of the internet), etc. Of course, if (relative) skill can change, then chasing it is useless anyway...
Insights will be appreciated