Using Prime Alpha to Separate Skill from Luck

Abstract

This article assesses the existence and persistence of manager skill by using a unique and broad database of institutional manager returns spanning U.S. large-cap, U.S. small-cap, global, and international equities. The authors define prime alpha as the residual return after adjusting for a set of common factors and find that it is persistent across time within each of the manager universes. Prime alpha is a strong indicator of manager skill because managers with high (low) prime alpha tend to continue to exhibit high (low) prime alpha. They also show evidence that raw manager returns are not persistent because they are influenced by the cyclicality in factor returns. Therefore, investors should use prime alpha to discern skill from luck among active managers.

TOPICS: Performance measurement, manager selection