Generalized Portfolio Performance Measures: Optimal Overweighting of Fees Relative to Sample Returns

Performance measures such as alpha and the Sharpe ratio are typically based on sample returns net of fees. This implies the same weighting to sample returns and to fees. However, sample return parameters are noisy estimates of true parameters, while fees are known with certainty. Thus, intuition suggests that fees should be given more weight than sample returns. We formalize this intuition, and derive the optimal overweighting of fees. We show that the resulting generalized performance measures are better predictors of future net performance than the standard performance measures, and they better explain future fund flows.