Evaluating Government Bond Fund Performance with Stochastic Discount Factors

Abstract

This paper evaluates the performance of government bond mutual funds with stochastic discount factors from continuous-time term structure models. The approach addresses the interim trading bias described by Goetzmann, Ingersoll and Ivkovic (2000) and Ferson and Khang (2002). It replaces the ad hoc selection of empirical factors and instruments with variables prescribed by theory. Time-aggregation of the models for discrete returns generates empirical factors that contribute explanatory power to the models, and may be useful in other settings. We provide the first conditional performance evaluation for US fixed income mutual funds. During 1986-2000 most government bond funds returned less on average than passive benchmarks that don't pay expenses, but not for all states of the term structure. The abnormal returns are reduced, and with a few interesting exceptions become insignificant, when we adjust for risk using the stochastic discount factors from term structure models.