Barras, Scaillet, and Wermers propose the false discovery rate (FDR) to separate skill (alpha) from luck in fund performance. Using simulations with parameters informed by the data, we find that this methodology is conservative and underestimates the proportion of nonzero-alpha funds. For example, 65% of funds with economically large alphas of (Formula presented.) are misclassified as zero alpha. This bias arises from the low signal-to-noise ratio in fund returns and the resulting low statistical power. Our results question FDR's applicability in performance evaluation and other domains with low power, and can materially change the conclusion that most funds have zero alpha.
- Mutual Funds
- False Discovery Rate