Mutual fund performance evaluation with active peer benchmarks

We propose a simple approach to account for commonalities in mutual fund strategies that relies solely on information on fund returns and investment objectives. Our approach augments commonly used factor models with an additional benchmark that represents an equal investment in all same-category funds, which we call an active peer benchmark (APB). We find that APBs substantially reduce the average time series correlation of residuals between individual funds within a group when added to a four-factor equity model (or to a seven-factor fixed-income model). Importantly, adding this APB significantly improves the selection of funds with future outperformance. (C) 2014 Elsevier B.V. All rights reserved.