48 Pages Posted: 22 Mar 2002
Date Written: November 2004
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: 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
By Bing Liang