Mutual Fund Managers: Real or Make-Belief Performance

Abstract

Alpha is a key indicator of mutual fund performance. It is equal to fund’s risk-adjusted return in excess of a benchmark index. We find that Norwegian mutual fund investors cannot always rely on alpha based on the fund-selected benchmark index, to differentiate fund quality. Many managers appear to pick benchmarks strategically and/or adjust their portfolios in a way that maximizes alpha. Our analysis sharpens previous studies of the US data, where only a few alternative benchmarks were considered based on a coarse classification of fund investment objectives and not on actual fund-selected benchmarks. The results are economically important. Compared to the best-fit alpha, alpha relative to the benchmark that best describes fund returns, alpha of an average equity fund appears to be 0,45 % higher per year. Among equity funds that “exaggerate” their alpha, the number is 1,83 %. We also find that the best-fit alpha, and not the fund’s official alpha, has a strong statistical association with fund closing decisions. Taken together, we find these results to be strong circumstantial evidence of strategic benchmark picking.