Searching for hedge-fund skill

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4 minute read

Hedge funds are complex investments, with varying risks, but a skilled hedge-fund manager is valuable and worth looking for. The question is – how do you identify a manager with superior skills?

An expert from The Australian National University (ANU), Associate Professor Geoff Warren, is proposing a new method for identifying hedge managers who are skilled through evaluating them against their peers.

Geoff, from the ANU College of Business and Economics (CBE) Research School of Finance, Actuarial Studies and Statistics (RSFAS), has co-authored a paper detailing the novel method, Identifying Hedge Fund Skill by Using Peer Cohorts, published in the Financial Analysts Journal (FAJ). This is Geoff’s third paper to be published in FAJ. 

Geoff and his co-authors, David Forsberg of BlueCove Limited, London, and David R. Gallagher of the RoZetta Institute, Sydney, were initially brought together because of Forsberg’s PhD research. Gallagher was Forsberg’s formal PhD supervisor, while Geoff was invited to be a member of the supervisory panel due to his industry knowledge.

“The hedge-fund space is a seething mass of strategies. So you really need to get down to the strategy level to understand what’s going on. The intuition behind what we’re doing is to try and identify individual strategies by looking at how funds are correlated, and then benchmark each fund against its peer group,” shares Geoff.

The ‘cohort model’ created by Geoff and his co-authors, enables better manager selection by forming peer groups of hedge funds executing similar invest¬ment strategies. 

Data for this study came from merging several fund databases. Peer cohorts were formed using return correlations.

Their research finds that the funds that outperform their peer group continue to do so for the next three to four years – a meaningful period of time. 

“We show that the cohort model better identifies manager skill than the widely-used ‘seven-factor model’, which only captures some dimensions of hedge-fund strategies,” explains Geoff. 

The cohort approach can enhance the construction of hedge fund-of-funds portfolios in two ways: First, by providing a better understanding of the various strategy groupings, and second, by isolating the best managers within each group. The cohort model also helps overcome the ‘missing variable’ problem encountered with factor models.  

A follow-on paper, Capacity Constraints in Hedge Funds: The Impact of Cohort Size on Fund Performance, was accepted by FAJ in October 2021. This paper indicates that capacity constraints for hedge funds can be better explained by cohort size and within-cohort competition, than they can by fund size in isolation.


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