Relative Hedge Fund Skill and the Informativeness of Cohort Alpha

Abstract

We propose a cohort model that evaluates hedge funds against peers which execute similar investment strategies. The method improves the identification of skilled managers by addressing the omitted variable problem present in traditional factor models. The method can enhance the construction of hedge fund-of-funds portfolios through isolating unique style groupings as well as the best managers within each group. 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