Hedge Funds: The Good, the Bad, and the Lucky
55 Pages Posted: 24 Aug 2011 Last revised: 18 Sep 2017
Date Written: October 10, 2015
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: Suggested Citation