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RFS Advance Access published online on May 17, 2007
Review of Financial Studies, 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{dagger}, Jonathan Ingersoll{dagger},*, Matthew Spiegel{dagger} and Ivo Welch{ddagger}
{dagger} Yale School of Management, PO Box 208200, New Haven, CT 06520-8200
{ddagger} Brown University, Department of Economics Box B, Providence, RI 02912

Corresponding author: jonathan.ingersoll{at}yale.edu (203) 432-5924


  Abstract

Numerous measures have been proposed to gauge the performance of active management. Unfortunately, these measures can be gamed. Our paper shows that gaming can have a substantial impact on popular measures even in the presence of high transactions costs. Our paper 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 non-linear payoff.

This paper has benefited from the comments of an anonymous referee and Maureen O'Hara at 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.


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