Benchmarking Mutual Fund Returns

Abstract

We question the appropriateness of using time-invariant indices as benchmarks and propose a regime-switching methodology to identify the time-varying de facto benchmarks from a pool of the market-based indices, with or without a risk-free asset. We highlight the benchmark mismatch phenomenon and the role of risk-free rate as an additional benchmark. Our de facto benchmark better capture fund styles than other benchmark choices, substantially improves the identification of significant fund alphas, and provides better out-of-sample forecasts. Importantly, we uncover several new findings in terms of fund performance evaluation using our identified benchmarks in this paper.

Keywords: Alpha, Benchmark, Measurement error, Mutual fund, Performance evaluation

JEL Classification: C15, G11, G12, G23