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

66 Pages Posted: 8 Dec 2004

See all articles by Naveen D. Daniel

Naveen D. Daniel

Drexel University - Department of Finance

Jeffrey L. Coles

University of Utah - Department of Finance

Federico Nardari

University of Melbourne - Department of Finance

Date Written: November 5, 2004

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

Suggested Citation

Daniel, Naveen D. and Coles, Jeffrey L. and Nardari, Federico, Do Model and Benchmark Specification Error Affect Inference in Measuring Mutual Fund Performance? (November 5, 2004). Available at SSRN: https://ssrn.com/abstract=628701 or http://dx.doi.org/10.2139/ssrn.628701

Naveen D. Daniel (Contact Author)

Drexel University - Department of Finance ( email )

LeBow College of Business
Philadelphia, PA 19104
United States
215-895-5858 (Phone)
215-895-2955 (Fax)

HOME PAGE: http://lebow.drexel.edu/Faculty/DanielN

Jeffrey L. Coles

University of Utah - Department of Finance ( email )

David Eccles School of Business
Salt Lake City, UT 84112
United States
801-587-9093 (Phone)

Federico Nardari

University of Melbourne - Department of Finance ( email )

Faculty of Economics and Commerce
Parkville, Victoria 3010 3010
Australia

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