Hedge Funds: The Good, the Bad, and the Lucky

Yong Chen, Michael Cliff and Haibei Zhao

Journal of Financial and Quantitative Analysis, 2017, vol. 52, issue 3, 1081-1109

Abstract: We develop an estimation approach based on a modified expectation-maximization (EM) algorithm and a mixture of normal distributions associated with skill groups to assess performance in hedge funds. By allowing luck to affect both skilled and unskilled funds, we estimate the number of skill groups, the fraction of funds from each group, and the mean and variability of skill within each group. For each individual fund, we propose a performance measure combining the fund’s estimated alpha with the cross-sectional distribution of fund skill. In out-of-sample tests, an investment strategy using our performance measure outperforms those using estimated alpha and t-statistic.

Date: 2017
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