Why not use SDF rather than beta models in performance measurement?

This paper analyzes performance measurement based on stochastic discount factors, compared to betamodels traditionally used in computing funds’ (Jensen) alphas. From a theoretical point of view, standardalphas suffer from several limitations. Our paper addresses this issue from an empirical point of view usinga sample of Swiss mutual funds from 2000 to 2011. Our results suggest that the key for a “fair”comparison between stochastic discount function (SDF) and beta models is the specification of the set ofprimitive assets used to calibrate the SDF function. Once this is established, the size of (absolute)performance differences considerably decreases between the two model families. However, there aresizeable performance deviations in the cross-section of funds if conditioning information is incorporated inthe tests, up to some 20 basis points per month, or about 2.3 % per year. In almost all cases, the SDFalphasare lower than the standard (Jensen) alphas. In absolute terms, the average SDF-basedunderperformance of the funds is way larger than the average expense ratio of the funds, both in aconditional and unconditional setting.