Benchmarking Measures of Investment Performance with Perfect-Foresight and Bankrupt Asset Allocation Strategies

Abstract

It is well known that popular measures of investment performance do not agree on the relative performance of passive portfolios, professionally managed funds, or various asset allocation strategies. In this article, the author shows that the problems are more fundamental. It benchmarks the performance measures against bankrupt asset allocation strategies that lose everything and perfect-foresight asset allocation strategies that yield returns beyond anyone's wildest dreams. Unbelievably, the risk-adjusted performance of some bankrupt strategies exceeds the risk-adjusted performance of all the perfect-foresight strategies! This occurs because the measures are based on average arithmetic returns which completely miss the fundamental importance of bankruptcy. Supplementing the measures with analyses of accumulated wealth, compound returns, or continuously compounded returns would alleviate the problem.

TOPICS: Mutual fund performance, accounting and ratio analysis, statistical methods