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...companies do not. A researcher finds that the former group performs less well than the latter group in the stock market. Is this difference related to the merger activity, or does it simply reflect underlying differences between the two groups of firms?
While the questions just raised may seem quite different, they can be answered using similar methods. In both cases, it is necessary to define some appropriate "benchmark" return. This benchmark return then can be compared to the actual return earned by the mutual fund manager, group of merged firms, or group of non-merged firms. The difference between the actual and benchmark returns then can be defined as an "abnormal" return. Abnormal returns then can be tested for statistical and economic significance.
These are the key steps in performance evaluation (PE), a methodology central to the investigation of many questions in financial economics. The seminal PE study, Jensen (1968), uses the classic Capital Asset Pricing Model (CAPM) as its benchmark and analyzes mutual funds (1); for the next 25 years, most PE studies followed this same strategy In the last ten years, though, researchers have developed many new models of benchmark returns and demonstrated their usefulness in PE studies of both investor performance and corporate finance. In this article, I illustrate some of these diverse applications with recent examples from my own work and with studies of investment newsletters, insider trading, and corporate governance. I then discuss a new approach to PE that allows fresh insights into the canonical mutual-fund topic. I conclude with a discussion of future directions for PE-based research.
Applications
Investment newsletters have been around since the early 1900s, and the current industry of over 500 active letters has about 2 million subscribers. The typical newsletter is produced by a small staff and provides a wide range of advice targeted at the retail investor. Is any of this advice useful? Using PE methodology, I analyze the performance of newsletters' equity recommendations using a dataset of 153 newsletters' that spans 17 years. (2) In contrast to most PE studies, this study's data contain information...
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