Relative Hedge Fund Skill and the Informativeness of Cohort Alpha

Abstract

We propose a cohort model for evaluating hedge funds against peer groups that execute similar investment strategies. The method improves the identification of manager skill by addressing the omitted variable problem present in traditional factor models, as well as constructing unique style groupings that can enhance the construction of hedge fund of- funds portfolios. The model displays strong ability to explain hedge fund returns out-of-sample, with cohort alpha more persistent than alpha based on the seven-factor model. A hedge fund-of-funds analysis finds significant performance enhancement from exposure to the best funds within each cohort.

Keywords: hedge funds; peer groups; clustering; relative performance; performance persistence

JEL Classification: G23