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

This paper is the first to present a two-stage peer group benchmarking approach to evaluate the performance of hedge funds. We present different ways of orthogonalizing the peer group benchmark and discuss their properties in general. We propose to orthogonalize the benchmark against all other exogenous factors. For a broad dataset we show that this approach captures much more commonalities in hedge funds returns compared to the standard methodology if only classical exogenous factors are used. As a result the empirical rankings of hedge funds on the basis of alphas received by this new approach change heavily. Therefore, the proposed two-stage peer group benchmark allows us to better determine which hedge fund managers outperformed the others in the past.