Investors may find more positive skill among mid-cap and small-cap mutual fund managers than among large-cap managers as an inverse relationship between skill and market capitalization exists. The evidence of skill, both positive and negative, is most apparent when fund returns are measured against an appropriate style benchmark instead of more broad measures.

Researchers determined these finding after looking at the monthly returns of over 2,300 funds for the period of 1990 through 2011. They analyzed returns using a traditional three-factor model espoused by Eugene Fama and Kenneth French, which considers excess returns, valuation and market size, and Mark Carhart’s four-factor model, which includes momentum. They then analyzed performance using the Russell style indexes. The study’s authors believe the Russell indexes provide a better measure of performance because they more closely resemble the objectives of the various funds and because they are investable options. [Various providers offer exchange-traded funds (ETFs) based on Russell indexes, including iShares and SPDR.]

Evidence of skill was hard to find among large-cap funds. The researchers say the outperformance of the top 1% to 2% of large-cap growth, blend and value funds was probably due to luck. At the other end of the return spectrum, there was “evidence of the antithesis of skill” for the worst-performing 5% of large-cap value and large-cap growth and the worst 10% of large-cap blend fund managers.

Skill was a contributor to the outperformance of the top 2% to 3% of mid-cap growth, blend and value funds, though the evidence was “less extreme” for mid-cap value funds. Negative skill contributed to the poor performance of the bottom 2% of mid-cap growth, bottom 10% of mid-cap blend and bottom 5% of mid-cap value fund managers.

Among small-cap funds, the study’s authors say they found “clear evidence of positive skill” for the top 10% of all small-cap styles. At the same time, there was less evidence of “negative skill” among small-cap funds. While the bottom 3% of small-cap blend managers demonstrated negative skill, there was “no evidence of negative skill amongst small-cap growth or value managers.” Rather, the authors concluded, “poor performance here seems to be due more to bad luck.”

Source: “On Luck Versus Skill When Performance Benchmarks Are Style-Consistent,” by Andrew Mason, Sam Agyei-Ampomah, Andrew Clare and Stephen Thomas, SSRN, April 2015.

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