Flaw in the fund skill/luck test method of Cuthbertson et al

Abstract

Cuthbertson et al have recently described a method that is claimed to be able to identify individual fund managers who exhibited skill over a long period in the past. The only input to the process is monthly fund returns. We suggest that a critical step in the Cuthbertson method is flawed. This step involves the study of the order statistics of period average fund returns. We construct a simple model to which the Cuthbertson method should apply. Simulations with the model conclusively demonstrate that the method fails to detect many funds with skill, and also erroneously identifies many funds as having skill they do not possess.