Neglected Risks in Mutual Fund Performance Measurement : An Additional Cost to Stock-Picking

I find that the risk correction in the Daniel et al. (1997) (DGTW) benchmarks is less than perfect. In light of the small 79bps selection skill DGTW find, a more precise risk measure is required. I use the utility based performance measure suggested by Goetzmann et al. (2007) (MPPM) and compare certainty equivalents instead of raw returns of assets and benchmarks. The imprecise risk correction in DGTW leads to an overestimation of fund manager stock picking skill of 47bps p.a. on average. Moreover, if the typical retail investor holds only one fund, he will lose another 87bps per annum due to poor diversification. There is large cross sectional variation between funds in the risks they take when stock picking and this cross sectional variation is persistent. Furthermore, the DGTW portfolios are a better benchmark for the MPPM than the market porfolio suggested by Goetzmann et al. (2007) as they more closely resemble fund style