Bridge over ocean
2 April 2021 Financial Analysts Journal Volume 77, Issue 2

Identifying Hedge Fund Skill by Using Peer Cohorts

  1. David Forsberg
  2. David R. Gallagher
  3. Geoffrey J. Warren

In analyzing hedge funds, “cohort” models formed by cluster analysis are more effective assessors and predictors of skill and performance than the established factor models.

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

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