{"id":1096,"date":"2026-10-05T04:10:58","date_gmt":"2026-10-05T04:10:58","guid":{"rendered":"https:\/\/david.bookstaber.com\/?p=1096"},"modified":"2026-10-05T04:15:28","modified_gmt":"2026-10-05T04:15:28","slug":"is-it-alpha-or-is-it-luck","status":"publish","type":"post","link":"https:\/\/david.bookstaber.com\/?p=1096","title":{"rendered":"Is It Alpha or Is It Luck?"},"content":{"rendered":"\n

My post on Moral Hazard in Asset Management<\/a> reminded me of a great paper by Foster & Young<\/a> (“Gaming Performance Fees by Portfolio Managers<\/a>,” QJE 2010). They showed that if an asset manager can sell options1<\/a><\/sup> then it is impossible to distinguish skill from luck based on a manager’s track record. In fact, if \u2013 as is often the case \u2013 managers are compensated <\/em>for positive track records, then there is a glaring incentive for unskilled managers to compete for assets by taking hidden risks.<\/p>\n\n\n\n

What’s the problem?  Let’s start with the traditional hedge fund pitch: A skilled manager finds a way to produce alpha <\/em>\u2013 for the purposes of this post, alpha can be described as profits beyond what can be earned from passive exposure to market investments<\/em>.  Call the legitimately skilled manager a “Maker” of alpha.2<\/a><\/sup>  Whatever alpha a Maker produces can be mimicked using skewed contracts that have no alpha.  An unskilled “Mimic” manager can create the appearance of alpha by tucking offsetting risk in a tail of his return distribution.  And you can too, using this little Mimic calculator:<\/p>\n\n\n\n