Is historical data a good estimate of the future risk of funds? - A study on the Swedish Hedge Fund market

Abstract

Predicting the future is something that every person trading with financial instruments or commodities, which have prices that depend on a future demand, tries to do. The objective of this thesis has been to examine whether or not historical returns are a good way to measure a funds future risk. To do this a new model for fund evaluation has been developed called the outside value method. The outside value method uses linear regression to build a predicted future average return based on the historical performance, and the historical standard deviation to build a prediction interval of 95% surrounding the average line. The model is built up using historical data up until one year before the last observed value. The prediction is then compared with the actual performance of this last observed year. Given the statistical prediction, 95% of the observation should lie within the interval which in this study would mean that approximately 10 out of the 204 observations. To limit the scope of the thesis one particular category of funds has been selected, hedge funds. Hedge funds is a collective name for a lot of different funds that uses different kinds of special trading strategies, such as short selling and leveraging by taking on debt. There is no clear definition on what a hedge fund is; however, most hedge funds are surrounded by some sort of secrecy regarding their trading strategy, something that strongly reduces the amount of information visible to the investor. Hedge funds claim to be a more stable investment since they aim to produce an absolute return no matter in which direction the market is going. The claim of stability together with the lack of information makes hedge funds a particularly interesting category for conducting a risk study. Of the 204 observations 8 ended up outside the interval which is close enough to the ten expected for the conclusion to be drawn that the hypothesis is true. Even though the average leads to this general conclusion there are still single outside values in the model that occurs with probability as low as 3,34499*10^-5, which may lead to questioning of the overall results. The key question, to whether or not the outside-value method is a useful tool for predicting the future risk of funds, is if the interval is narrow enough for a prediction to be of any value. This is something that is left for discussion and most probably something that is connected to personal preferences.