Portfolio Performance Evaluation: Old Issues and New Insights

This paper presents a simple model that provides insights about various measures of portfolio performance. The model explores three criticisms of these measures: (i) the inability to identify an appropriate benchmark portfolio; (ii) the possibility of overestimating risk because of market timing ability; and (iii) the failure of informed investors to earn positive risk-adjusted returns because of increasing risk aversion. The paper argues that these are not serious impediments to performance evaluation. In particular, it shows (i) that the appropriate benchmark portfolio is the unconditional mean-variance efficient portfolio of the evaluated investor’s tradable assets, even when the investor does not optimally hold the mean-variance efficient portfolio; (ii) that the market timing risk-adjustment problem can be overcome with new measures; and (iii) that informed investors display negative risk-adjusted returns only for pathological preferences that treat risky assets as Giffen goods.