Do Model and Benchmark Specification Error Affect Inference in Measuring Mutual Fund Performance?

Abstract

This paper examines the implications for mutual fund performance measurement of two likely sources of specification error. We compare three well-known models, those of Jensen (1968), Treynor and Mazuy (1966), and Henriksson and Merton (1981), and two commonly-used timing benchmarks, the S&P 500 index and CRSP value-weighted index. The practical question we address is whether investors and researchers are likely to make invalid inferences about fund manager performance when using the wrong model or benchmark. Based on Monte Carlo simulations calibrated to real data, we find that: (1) model misspecification results in severely biased measures of both selectivity and timing ability, while biases in measures of overall ability are economically insignificant; (2) benchmark misspecification results in qualitatively similar inferences, although statistical significance is not as strong; and (3) the power of detecting ability for an individual fund or for distinguishing between a good fund from a bad fund is typically quite low and such power is not appreciably altered by model and benchmark misspecification. These results are robust to alternative asset pricing specifications (CAPM versus Carhart 4-factor) and the periodicity of the simulation (calibrated to daily versus monthly data).

Keywords: Mutual funds, performance evaluation, selectivity, market timing, specification errors

JEL Classification: G11, G12, G23