Does the Choice of Model or Benchmark Affect Inference in Measuring Mutual Fund Performance?

57 Pages Posted: 16 Mar 2006

See all articles by Jeffrey L. Coles

Jeffrey L. Coles

University of Utah - Department of Finance

Naveen D. Daniel

Drexel University - Department of Finance

Federico Nardari

University of Melbourne - Department of Finance

Date Written: January 31, 2006

Abstract

We address the practical question of whether investors and researchers are likely to make invalid inferences about fund manager performance when using the wrong model and/or benchmark. We consider 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. Although prior studies recognize the possibility of model and benchmark misspecification, the existing literature does not explore empirically the existence, magnitude, and significance, if any, of potential inferential errors. Based on Monte Carlo simulations calibrated to real mutual fund data, we find that: (1) model misspecification results in severely biased measures of both selectivity and timing ability, especially for extreme (good and bad) performers; (2) but biases in measures of overall performance are economically insignificant; (3) benchmark misspecification results in qualitatively similar difficulties, with the addition that overall performance as well can be biased; and (4) model and benchmark misspecification do not appreciably alter the power to detect ability and distinguish a good fund from a bad fund. These results are robust to alternative asset pricing specifications, alternative simulation schemes, varying length of the return series, and periodicity of the simulated series. The use of daily fund returns amplifies our conclusions about the biases induced by model misspecifications. Moreover, the biases we identify appear to be difficult to correct by using standard model selection criteria and misspecification tests. If the benchmark is known but the timing model is not, investors should use measures of overall performance to evaluate funds and managers.

Keywords: Mutual Funds Performance, Market Timing, Model Misspecification, Bootstrap

JEL Classification: G12, G20, G23

Suggested Citation

Coles, Jeffrey L. and Daniel, Naveen D. and Nardari, Federico, Does the Choice of Model or Benchmark Affect Inference in Measuring Mutual Fund Performance? (January 31, 2006). EFA 2006 Zurich Meetings. Available at SSRN: https://ssrn.com/abstract=891224 or http://dx.doi.org/10.2139/ssrn.891224

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)

Naveen D. Daniel

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

Federico Nardari (Contact Author)

University of Melbourne - Department of Finance ( email )

Faculty of Economics and Commerce
Parkville, Victoria 3010 3010
Australia

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