of The RISE
The mutual fund industry is built on a web of deeply satisfying myths of superstar fund man- agers, benchmarks, quality fund families, quests for value and high-flying recent returns. An iconic television ad right that aired before the
internet bubble burst showed Janus fund analysts inspecting
underground fiber optic cables to literally dig up value for investors. Fund investors like a good story.
In academic finance, the story isn’t nearly as interesting.
Common mutual fund narratives are relegated to the fiction
section of the bookshelf. Why do financial scientists have
such a different view of investing than many in the financial
Two innovations changed the way financial economists
view the value of stock picking. The first was the advent of
electronic computing, which allows scientists to study moun-
tains of returns data. The second innovation was the Sharpe/
Lintner capital asset pricing model (CAPM). Computers allow
scientists to test whether markets efficiently priced securities
based on the amount of risk that an investor couldn’t get rid
of through diversification.
But, arguably, the most important innovation in the science
of mutual fund analysis was the movement of a young scholar
named Eugene Fama from romance languages into econom-
ics. Fama’s Ph.D. thesis in 1965 used the power of advanced
computing to show that stock prices tended to follow a random
walk. Fama also contributed to developing a new method of
analyzing how stocks respond to new information that provided
a window into the remarkable efficiency of financial markets.
Then in 1967 Fama’s graduate student, Michael Jensen, de-
cided to see whether returns on mutual funds could be explained
by the exciting new CAPM equation. Jensen simply tested if
systematic risk explained the variation in fund performance.
Could fund managers provide a higher return than would
be predicted based on their risk (or beta)? Could the best
funds provide a consistently higher return than an investor
could achieve by just holding a market portfolio with the same
amount of risk?
The scientific evidence points to where advisors can provide
significant value to clients — not in short-term stock picking
but in helping them achieve long-term goals