28 Pages Posted: 25 Feb 2016
Date Written: February 24, 2016
We propose a Markov regime-switching approach accounting for false discoveries in order to measure hedge fund performance. It enables us to extract information from both time-series and cross-sectional dimensions of panels of individual hedge fund returns in order to distinguish between skilled, unskilled and zero-alpha funds for a given state of the economy. Applying our approach to individual hedge funds belonging to the Long/Short Equity Hedge strategy, we find that their performance cannot be explained by luck alone, and that the proportion of zero-alpha funds in the population decreases when accounting for alpha regime dependence. However, the proportion of truly skilled funds is higher during expansion periods, while unskilled funds tend to be more numerous during recession periods. Moreover, sorting on regime dependent alphas instead of unconditional alphas improves investors' ability to select funds that outperform their benchmarks in both regimes of the economy by maximizing the performance persistence effect of top performer fund portfolios.
Keywords: Hedge fund performance, Markov regime-switching factor models, false discovery rates, business cycles, portfolio choice
JEL Classification: C58, G11, G12
Suggested Citation: Suggested Citation
Mero, Gulten, Measuring Hedge Fund Performance: A Markov Regime-Switching with False Discoveries Approach (February 24, 2016). Available at SSRN: https://ssrn.com/abstract=2737385 or http://dx.doi.org/10.2139/ssrn.2737385