Chapter 1 - The financial economics of performance measurement

Abstract

This chapter presents various performance measures that have been constructed over the years with the aim of better evaluating and assessing the fund manager's abilities. In managing funds, two different techniques can be used—passive and active. Passive portfolio management entails what is commonly referred to as a buy-and-hold strategy, where the weights on the securities constituting the portfolio are set at the beginning of the investment period and are then held constant until the end, with only minor changes. The assumptions that lie behind passive portfolio management are market efficiency and homogeneity of expectations. If markets are efficient, the fund manager cannot capitalize on any mispricing of securities and gain from actively trading them. Moreover, if all investors have homogeneous expectations, the fund manager cannot take advantage of any differences in the securities market expectations regarding returns and risk to generate abnormal performance from active trading. Assessing whether active managers have genuine abilities in completing tasks, and whether the high fees and expenses that they charge are justified by those superior abilities in the form of excess returns, is the aim of the performance literature. Consequently, the literature has devised, over the years, several different performance measures that help determine these issues.