TY - JOUR
AU - Baks,Klaas
AU - Metrick,Andrew
AU - Wachter,Jessica
TI - Bayesian Performance Evaluation
JF - National Bureau of Economic Research Working Paper Series
VL - No. 7069
PY - 1999
Y2 - April 1999
DO - 10.3386/w7069
UR - http://www.nber.org/papers/w7069
L1 - http://www.nber.org/papers/w7069.pdf
N1 - Author contact info:
Klaas Baks
E-Mail: Klaas_Baks@bus.emory.edu
Andrew Metrick
Yale School of Management
135 Prospect Street
P.O. Box 208200
New Haven, CT 06520
Tel: 203/432-3069
E-Mail: metrick@yale.edu
Jessica Wachter
Department of Finance
2300 SH-DH
The Wharton School
University of Pennsylvania
3620 Locust Walk
Philadelphia, PA 19104
Tel: 215/898-7634
Fax: 215/898-6200
E-Mail: jwachter@wharton.upenn.edu
AB - This paper proposes a Bayesian method of performance evaluation for investment managers. We begin with a flexible set of prior beliefs that can be elicited without any reference to probability distributions or their parameters. We then combine these prior beliefs with a general multi-factor model and derive an analytical solution for the posterior expectation of alpha', the intercept term from the model. This solution can be computed using only a few extra steps beyond maximum likelihood estimation and does not require a comprehensive or bias-free database. We then apply our methodology to a sample of domestic diversified equity mutual funds and ask what prior beliefs would imply zero investment in active managers?' To justify such a zero-investment strategy, we find that a mean-variance investor would need to believe that less than 1 out of every 100,000 managers has an expected alpha greater than 25 basis points per month. Overall, our analysis suggests that even when the average manager is expected to underperform passive benchmarks, it requires very strong prior beliefs to imply zero investment in managers with the best past performance.
ER -