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Hedge Funds: The Good, the Bad, and the Lucky

55 Pages Posted: 24 Aug 2011 Last revised: 18 Sep 2017

Yong Chen

Texas A&M University - Department of Finance

Michael T. Cliff

Analysis Group

Haibei Zhao

Lehigh University

Date Written: October 10, 2015

Abstract

We develop an estimation approach based on a modified EM algorithm and a mixture of Normal distributions associated with skill groups to assess performance in hedge funds. By allowing luck to affect both skilled and unskilled funds, we estimate the number of skill groups, the fraction of funds from each group, and the mean and variability of skill within each group. For each individual fund, we propose a performance measure combining the fund’s estimated alpha with the cross-sectional distribution of fund skill. In out-of-sample tests, an investment strategy using our performance measure outperforms those using estimated alpha and t-statistic.

Keywords: Hedge funds, mixture Normal distributions, performance evaluation, EM algorithm, performance persistence

JEL Classification: C13, G11, G23

Suggested Citation

Chen, Yong and Cliff, Michael T. and Zhao, Haibei, Hedge Funds: The Good, the Bad, and the Lucky (October 10, 2015). Journal of Financial and Quantitative Analysis (JFQA), Vol. 52, No. 3, June 2017, pp. 1081-1109. Available at SSRN: https://ssrn.com/abstract=1915511 or http://dx.doi.org/10.2139/ssrn.1915511

Yong Chen (Contact Author)

Texas A&M University - Department of Finance ( email )

360 Wehner Building
College Station, TX 77843-4218
United States

Michael T. Cliff

Analysis Group ( email )

800 17th St, N.W.
Suite 400
Washington, DC 20006
United States
(202) 530-2010 (Phone)

Haibei Zhao

Lehigh University ( email )

621 Taylor Street, RBC 323
Bethlehem, PA PA 18018
United States

HOME PAGE: http://https://sites.google.com/a/lehigh.edu/haibei/

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