Performance Evaluation with Stochastic Discount Factors

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