Identifying Hedge Fund Skill Using Peer Cohorts

Abstract

We propose a cohort model that evaluates hedge funds against peer groups executing similar investment strategies formed using return correlations. Our method improves identification of skilled managers, as evidenced by a strong ability to explain hedge fund returns out-of-sample together with cohort alpha being more persistent than alpha based on the widely-accepted seven-factor model. A hedge fund-of-funds analysis finds significant performance enhancement from exposure to the best funds within each cohort. The cohort approach can enhance the construction of hedge fund-of-funds portfolios by isolating strategy groupings as well as the best managers within each group.

Keywords: Hedge funds, performance evaluation, performance persistence, manager selection, portfolio construction, cluster analysis

JEL Classification: G23