Measuring the performance of hedge funds using two-Stage endogenous benchmarks

This is the first paper studying the performance of hedge funds using the concept of endogenous benchmarks. A two-stage endogenous benchmark approach is used to investigate a number of alternatives for measuring hedge fund performance. Our findings support the use of orthogonalized endogenous benchmarks as compared to models with no benchmarks or non-orthogonalized benchmarks. In general, our findings indicate that endogenous benchmarks should be orthogonalized against all exogenous factors. However, the form of orthogonalization affects the rankings of the hedge funds within the main-strategies of the hedge funds studied. Consequently, rankings can be significantly different at the sub-group level with different orthogonalization methods for the endogenous benchmarks. Therefore, depending on the nature of the examiner’s need, endogenous benchmark might be employed after the orthogonalization ‘without group alphas’, which ranks the funds with reference to the exogenous factors considered, or the orthogonalization ‘with group alphas’, which ranks the funds with reference to both the peer group and the exogenous factors.