This study uses a stochastic frontier approach to evaluate firm efficiency. The resulting efficiency score, based on firm characteristics, is the input for performance evaluation. The portfolio composed of highly efficient firms significantly underperforms the portfolio composed of inefficient firms even after adjustment for firm characteristics and risk factors, suggesting a required premium for the inefficient firms. The difference in performance between the two portfolios remains for at least five years after the portfolio formation year. In addition, firm efficiency exhibits significant explanatory power for average equity returns in cross-sectional analysis.

This paper compares an international two-index model to an International Arbitrage Pricing Theory (IAPT) two-factor model to evaluate the performance of 37 U.S.-based international mutual funds over the 1985–1993 period. Results from the index model confirm prior research that international funds perform as well as the market proxy. In contrast, the IAPT model implies superior investment performance by the international funds. Moreover, the two models produce different relative performance rankings. Intertemporal comparisons of the models indicate that the multifactor IAPT model better reflects the international equity return-generating process.