Portfolio Performance Manipulation and Manipulation-Proof Performance Measures

48 Pages Posted: 22 Mar 2002  

William N. Goetzmann

Yale School of Management - International Center for Finance; National Bureau of Economic Research (NBER)

Jonathan E. Ingersoll Jr.

Yale School of Management - International Center for Finance

Matthew I. Spiegel

Yale University - Yale School of Management, International Center for Finance

Ivo Welch

University of California, Los Angeles (UCLA); National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: November 2004

Abstract

Over the years numerous portfolio performance measures have been proposed. In general they are designed to capture some particular enhancement that might result from active management. However, if a principal uses a measure to judge an agent, then the agent has an incentive to game the measure. Our paper shows that such gaming can have a substantial impact on a number of popular measures even in the presence of extremely high transactions costs. The question then arises as to whether or not there exists a measure that cannot be gamed? As this paper shows there are conditions under which such a measure exists and fully characterizes it. This manipulation-proof measure looks like the average of a power utility function, calculated over the return history. The case for using our alternative ranking metric is particularly compelling in the hedge fund industry, in which the use of derivatives is unconstrained and manager compensation itself induces a non-linear payoff and thus encourages gaming.

JEL Classification: G0, G1, G2

Suggested Citation

Goetzmann, William N. and Ingersoll, Jonathan E. and Spiegel, Matthew I. and Welch, Ivo, Portfolio Performance Manipulation and Manipulation-Proof Performance Measures (November 2004). Yale ICF Working Paper No. 02-08; AFA 2003 Washington, DC Meetings. Available at SSRN: https://ssrn.com/abstract=302815 or http://dx.doi.org/10.2139/ssrn.302815

William N. Goetzmann (Contact Author)

Yale School of Management - International Center for Finance ( email )

165 Whitney Ave.
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HOME PAGE: http://viking.som.yale.edu

National Bureau of Economic Research (NBER)

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Jonathan E. Ingersoll Jr.

Yale School of Management - International Center for Finance ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States
203-432-5924 (Phone)
203-432-6974 (Fax)

Matthew I. Spiegel

Yale University - Yale School of Management, International Center for Finance ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States
203-432-6017 (Phone)
203-432-8931 (Fax)

HOME PAGE: http://som.yale.edu/~spiegel

Ivo Welch

University of California, Los Angeles (UCLA) ( email )

110 Westwood Plaza
C519
Los Angeles, CA 90095-1481
United States
310-825-2508 (Phone)

HOME PAGE: http://www.ivo-welch.info

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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