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

This paper analyzes performance measurement based on stochastic discount factors, compared to beta modelstraditionally used in computing funds’ (Jensen) alphas. From a theoretical point of view, standard alphas sufferfrom several limitations. Our paper addresses this issue from an empirical point of view using a sample of Swissmutual funds from 2000 to 2011. Our results suggest that the key for a “fair” comparison between SDF and betamodels is the specification of the set of primitive 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 are sizeable performance deviations in the cross‐section of funds if conditioning information is incorporatedin the tests, up to some 20 basis points per month, or about 2.3% per year. In almost all cases, the SDF‐alphas arelower than the standard (Jensen) alphas. In absolute terms, the average SDF‐based underperformance of the fundsis way larger than the average expense ratio of the funds, both in a conditional and unconditional setting.