Evaluating the performance of hedge funds using two-stage peer group benchmarks

This article proposes a two-stage peer group benchmarking approach to evaluate the performance of hedge funds. We present different ways of orthogonalizing the peer group benchmarks and discuss their general properties. We then orthogonalize the relevant benchmarks against predetermined exogenous factors. For a broad dataset we show that this approach captures much more commonalities in hedge funds returns when compared with the standard methodology of using exogenous factors only. As a consequence, the empirical rankings of hedge funds, on the basis of alphas, change considerably. Therefore, the proposed two-stage peer group benchmark allows us to identify which hedge fund managers outperformed their cohorts.