By constructing artificial mutual funds with known levels of investment ability, we evaluate a large set of SDF models. We find that the measures of performance are not highly sensitive to the SDF model, and that most of the models have a mild negative bias when performance is neutral. We use the models to evaluate a sample of U.S. equity mutual funds. Adjusting for the observed bias, we find that the average mutual fund has enough ability to cover its transactions costs.
Extreme funds are more likely to have good rather than poor risk adjusted performance.
Our analysis also reveals a number of implementation issues relevant to other applications of SDF models. The actions of the monetary authority are seldom taken into account in continuous-time arbitrage pricing models of the term structure of interest rates. This is likely to be problematic in many economies. In the U.S., for example, the Federal Reserve sets targets for interest rates which it enforces through direct market intervention. In this paper we develop a model in which the short rate is subject to a control which keeps it close to a target which changes from time to time.