Endogenous Benchmarks

This paper develops a new approach that controls for commonalities in actively managedinvestment fund returns when measuring their performance. It is well-known that manyinvestment funds may systematically load on common priced factors omitted from popularmodels, exhibit similarities in their choices of specific stocks and industries, or vary theirrisk-loadings in a similar way over time. We propose a parsimonious model that uses thereturn on the group of mutual funds as a benchmark for each individual fund within thatgroup. We demonstrate that this model substantially reduces the correlation between fundresiduals from standard models used for equity and fixed-income funds, and improves theestimates of fund α’s and β’s from commonly used equity and fixed-income models