Endogenous Benchmarks

45 Pages Posted: 21 Mar 2009

See all articles by David L. Hunter

David L. Hunter

University of Queensland

Eugene Kandel

Hebrew University of Jerusalem - Department of Economics; Centre for Economic Policy Research (CEPR)

Russ Wermers

University of Maryland - Robert H. Smith School of Business

Shmuel Kandel (deceased)


Multiple version iconThere are 2 versions of this paper

Date Written: March, 18 2009


This paper develops a new approach to control for commonalities in actively managed investment fund returns when measuring their performance. Many investment fund managers systematically load on common priced factors that are omitted from popular models, exhibit similarities in their choices of specific stocks and industries, or vary their factor-loadings in a similar way over time. These commonalities create well-known problems in measuring the performance of groups of funds, since it is difficult to control for their correlated residuals in commonly used models. While, in principle, it is possible to add factors to control for these commonalities, the large number of potential strategies used by fund managers make this approach untenable.

In this paper, we propose a simple approach to account for the commonalities in fund strategies that only uses information on fund returns and the investment objective of the fund. Our approach is to form an additional factor from the return on the group of funds to which a given fund belongs. We call this additional factor an "endogenous benchmark," since each fund manager chooses the group within which it intends to compete. This choice of a group by the manager indicates the set of strategies from which the manager will choose in order to compete.

Using only the returns and investment objectives of funds, our endogenous benchmarks substantially reduce the cross-sectional dependencies of residuals, across groups of funds and across individual funds within a group. Specifically, more than half of the cross-sectional correlations between individual funds is eliminated with our method. We also show that this improvement in estimation of alphas results in a better identification of U.S. equity and fixed-income funds with persistent performance. For instance, relative to a standard four-factor model, our model generates outperformance of more than 3% per year among U.S. growth equity funds.

Suggested Citation

Hunter, David L. and Kandel, Eugene and Wermers, Russell R. and Kandel (deceased), Shmuel, Endogenous Benchmarks (March, 18 2009). AFA 2010 Atlanta Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1364505 or http://dx.doi.org/10.2139/ssrn.1364505

David L. Hunter

University of Queensland ( email )

United States
733468094 (Phone)

HOME PAGE: http://https://www.business.uq.edu.au/staff/david-hunter

Eugene Kandel

Hebrew University of Jerusalem - Department of Economics ( email )

School of Business
Mount Scopus
Jerusalem 91905
+972 2 588 3137 (Phone)
+972 2 581 6071 (Fax)

Centre for Economic Policy Research (CEPR)

United Kingdom

Russell R. Wermers (Contact Author)

University of Maryland - Robert H. Smith School of Business ( email )

Department of Finance
College Park, MD 20742-1815
United States
301-405-0572 (Phone)
301-405-0359 (Fax)

HOME PAGE: http://www.rhsmith.umd.edu/finance/rwermers/

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