Mar 24, 2015
Q&A
What can one learn from one, three, or five years of past returns about a manager’s skill or about the future performance of an investment?

EFF/KRF: The short answer: usually almost nothing. The longer answer depends on the specific investment and what you are trying to measure. Many decades of prior returns, for example, are not enough to make a precise estimate of the expected return on the stock market or of factor risk premiums. (See "Volatility and Premiums.") The answer is similar for investors trying to assess the prospects of a typical hedge fund. Five, 10, or even 20 years is almost certainly too short to say much about the manager’s skill or the fund’s future returns. On the other hand, one can quickly discover whether an index fund is reproducing its target index return because there is a perfect benchmark. Most investments are somewhere between hedge funds and index funds. One can use a benchmark (or asset pricing model) to eliminate some of the noise, but the randomness that remains usually makes it hard to determine whether good returns are the result of luck or skill, even with decades of past returns. (See "Luck versus Skill in Mutual Fund Performance.") This is especially true for active managers since active management almost by definition means low diversification and high volatility of unexpected returns (noise).

 
ABOUT FAMA AND FRENCH
Eugene F. Fama
The Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business
Kenneth R. French
The Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College
This information is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily Dimensional Fund Advisors and does not represent a recommendation of any particular security, strategy or investment product. Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.