De facto time-varying indices-based benchmarks for mutual fund returns

Abstract

We question time-invariant indices as fund benchmarks and propose a regime-switching methodology to identify time-varying de facto benchmarks from a pool of market-based indices, with or without a risk-free asset. To ameliorate the benchmark mismatch issue, we highlight the importance of using time-varying indices-based benchmarks for fund performance evaluation. Our de facto benchmark captures fund styles better than other benchmark choices, substantially improves the identification of significant fund alphas, and provides better out-of-sample forecasts. We uncover several new findings in terms of fund performance evaluation using our de facto benchmarks.