Evaluating Fixed Income Fund Performance with Stochastic Discount Factors
Wayne Ferson, Boston College
Darren Kisgen, University of Washington
Tyler Henry, University of Washington

This paper shows how to evaluate the performance of managed portfolios using stochastic discount factors (SDFs) from continuous-time term structure models. Our approach addresses a bias in performance measurement, described by Goetzmann, Ingersoll and Ivkovic (2000) and Ferson and Khang (2002), that arises when fund managers may trade within the return measurement interval. The solution gives rise to empirical factors formed as time-averages of the underlying state variables in the model. We find that these empirical factors contribute explanatory power in factor model regressions and reduce the pricing errors of the SDF models for dynamic strategy returns. We illustrate our approach on a sample of U.S government bond funds during 1986-2000. This example represents the first conditional performance evaluation for US fixed income mutual funds. During 1986-2000 government bond funds as a group returned less on average than bond portfolios that don’t pay expenses. Their returns vary more across term structure states than across characteristics-grouped portfolios formed on the basis of fund size, age, expenses and other common characteristics. High spot rates, high term structure slopes and low term structure convexity states predict higher conditional expected returns. However, after risk adjustment none of these performance differences is economically significant.

Accurate performance evaluation is of great importance to our members. Sponsors are interested in evaluating managers and managers must evaluate their performance to manage it. This paper identifies problems associated with performance evaluation of bond portfolios that arise because managers trade within the return measurement interval. The authors provide improved methods that better discriminate among returns, and in particular, show that actively managed government bond returns did not underperform passive performance measures in 1986-2000 as previously thought.