Benchmarking mutual fund alpha

Abstract

Purpose The standard market models assume that all investors are rational with the same level of risk aversion, whereas investors in the real world are neither rational nor homogeneous. This contrast makes these models inappropriate for evaluating manager skill. The purpose of this paper is to attempt to bridge the gap between model assumption and fund investment practice. Design/methodology/approach This study proposes a series of modified models using the excess return of peer funds to estimate fund alpha. In these models, the market excess return in the standard market models is replaced with the average excess return of bootstrapped funds. In addition, the author examines the reasons for the difference between the modified models and the standard models. Findings The modified models better explain the variation of fund returns, and they exhibit that a considerably higher percentage of funds can earn positive alpha, thus the skill of fund managers is underestimated based on the standard market models. Originality/value The proposed models provide a more reliable method for investors to identify skilled fund managers, and they can also serve as an objective benchmark in evaluating fund performance and in designing manager compensation packages.