Bayesian Performance Evaluation

57 Pages Posted: 12 Jul 2000 Last revised: 16 Apr 2008

See all articles by Klaas Baks

Klaas Baks

Emory University - Department of Finance

Jessica A. Wachter

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Andrew Metrick

Yale School of Management; National Bureau of Economic Research (NBER); Yale University - Yale Program on Financial Stability

Multiple version iconThere are 2 versions of this paper

Date Written: April 1999

Abstract

This paper proposes a Bayesian method of performance evaluation for investment managers. We begin with a flexible set of prior beliefs that can be elicited without any reference to probability distributions or their parameters. We then combine these prior beliefs with a general multi-factor model and derive an analytical solution for the posterior expectation of alpha', the intercept term from the model. This solution can be computed using only a few extra steps beyond maximum likelihood estimation and does not require a comprehensive or bias-free database. We then apply our methodology to a sample of domestic diversified equity mutual funds and ask what prior beliefs would imply zero investment in active managers?' To justify such a zero-investment strategy, we find that a mean-variance investor would need to believe that less than 1 out of every 100,000 managers has an expected alpha greater than 25 basis points per month. Overall, our analysis suggests that even when the average manager is expected to underperform passive benchmarks, it requires very strong prior beliefs to imply zero investment in managers with the best past performance.

Suggested Citation

Baks, Klaas and Wachter, Jessica A. and Metrick, Andrew, Bayesian Performance Evaluation (April 1999). NBER Working Paper No. w7069. Available at SSRN: https://ssrn.com/abstract=227424

Klaas Baks (Contact Author)

Emory University - Department of Finance ( email )

Atlanta, GA 30322-2710
United States

Jessica A. Wachter

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-7634 (Phone)
215-898-6200 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Andrew Metrick

Yale School of Management ( email )

165 Whitney Avenue
New Haven, CT 06511
United States
(203)-432-3069 (Phone)

HOME PAGE: http://faculty.som.yale.edu/andrewmetrick/

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Yale University - Yale Program on Financial Stability

165 Whitney Avenue
P.O. Box 208200
New Haven, CT 06520-8200
United States

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