When Benchmark Indices have Alpha: Problems with Performance Evaluation

Abstract

Standard Fama-French and Carhart models produce economically and statistically significant nonzero alphas even for passive benchmark indices such as the S&P 500 and Russell 2000. The alphas arise from the disproportionate weight the Fama-French factors place on small value stocks which have performed well, and from the CRSP value-weighted market index which is a downward-biased benchmark for U.S. stocks. We explore alternative ways to construct these factors as well as alternative models constructed from common and easily tradable benchmark indices. Our index-based models outperform the standard models both in terms of asset pricing tests and performance evaluation of mutual fund managers.