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RFS Advance Access originally published online on May 17, 2007
Review of Financial Studies 2007 20(5):1503-1546; doi:10.1093/rfs/hhm025
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Copyright © The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies.

Portfolio Performance Manipulation and Manipulation-proof Performance Measures

William Goetzmann, Jonathan Ingersoll and Matthew Spiegel
Yale School of Management, PO Box 208200, New Haven, CT 06520-8200

Ivo Welch
Brown University, Department of Economics Box B, Providence, RI 02912

Address correspondence to Jonathan Ingersoll, Yale School of Management, PO Box 208200, New Haven, CT 06520–8200, or e-mail: jonathan.ingersoll{at}yale.edu.

JEL: G11, G23, G24


  Abstract

Numerous measures have been proposed to gauge the performance of active management. Unfortunately, these measures can be gamed. Our article shows that gaming can have a substantial impact on popular measures even in the presence of high transactions costs. Our article shows there are conditions under which a manipulation-proof measure exists and fully characterizes it. This measure looks like the average of a power utility function, calculated over the return history. The case for using our alternative ranking metric is particularly compelling for hedge funds whose use of derivatives is unconstrained and whose managers' compensation itself induces a nonlinear payoff.

This article has benefited from the comments of an anonymous referee and Maureen O'Hara at the The Review of Financial Studies and numerous colleagues including the participants at the Five Star Conference hosted by New York University, the Hedge Fund Conference hosted by Borsa Italiana, and the Berkeley Program in Finance.

The author order has been corrected.


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