NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Performance Evaluation with Stochastic Discount Factors

Heber Farnsworth, Wayne E. Ferson, David Jackson, Steven Todd

NBER Working Paper No. 8791
Issued in February 2002
NBER Program(s):   AP

We study the use of stochastic discount factor (SDF) models in evaluating the investment performance of portfolio managers. By constructing artificial mutual funds with known levels of investment ability, we evaluate a large set of SDF models. We find that the measures of performance are not highly sensitive to the SDF model, and that most of the models have a mild negative bias when performance is neutral. We use the models to evaluate a sample of U.S. equity mutual funds. Adjusting for the observed bias, we find that the average mutual fund has enough ability to cover its transactions costs. Extreme funds are more likely to have good rather than poor risk adjusted performance. Our analysis also reveals a number of implementation issues relevant to other applications of SDF models.

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Document Object Identifier (DOI): 10.3386/w8791

Published: Farnsworth, Heber, Wayne Ferson, David Jackson and Steven Todd. "Performance Evaluation With Stochastic Discount Factors," Journal of Business, 2002, v75(3,Jul), 473-503.

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