Assignment 1

How does an investment in a hedge fund compare to a passive buy-and-hold approach?

Thomas Newcombe | Applied Financial Techniques 2 | November 21, 2015

Thomas Newcombe

Finance and Investment

Rob Hayward

Introduction
The comparison of an investment in a hedge fund and a passive buy and hold approach has been disputed many
times by a vast number of theorists. The largest difference between the two approaches is the amount of risk in the
investment. This is due to the large difference in risk between the two investments. One of the most basic ways to
show risk and explain how it affects investments is the risk return diagram. This is shown below.

Return
Risk
This graph shows that greater risk means greater return, and is a key point in the comparison between these two
investments. When comparing risk between a hedge fund and a passive it is important to note that a hedge fund is
proactive in its investment approach with managers buying and selling very quickly to make their return. In
comparison to this a buy and hold approach is very passive and focused around long term trading.
Within this assignment this comparison with be explored in greater depths by analyzing previous prices from a
hedge fund and stock index, which is generally used for a buy and hold approach. I have sourced prices from a
hedge fund and index from the past 18 years and have used this for various calculations which can be used for
comparison. However the data used varies as the hedge fund data is a mix of yearly and quarterly prices and the
index is monthly prices. However the figures are still a suitable base for comparison between the two investment
strategies.

Calculation Comparison
Using the data it is possible to find equations which can be used to compare the two methods of investment, such as
mean, standard deviation, and others. For example, the mean price of the hedge fund is 1624.29, while the mean
price of the index is 5568.18, making it substantially larger than the hedge fund. However, it is important to realize
that, even though the mean price for the index is larger, it does not accurately represent the returns from and
investment, meaning that the investment in the hedge fund could still be a more suitable choice.
The second important calculation to consider when comparing the two investments is the standard deviation. For
the hedge fund in this report, the standard deviation has been calculated as 779.60, and for the index is 846.34.
When comparing the two figures for an investment, it is important to note that the hedge fund has the lower
standard deviation, meaning that there is a smaller spread in the data. This could mean that the hedge fund price
fluctuates less than the index price.
Other calculations which can be made to compare the two investments are skewness and kurtosis. These measure
how normally distributed the data is. For the data in this report, both skewness and kurtosis are negative for both
the investments, with skewness for the hedge fund being -0.72, kurtosis being -0.39, and skewness for the index

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Thomas Newcombe

Finance and Investment

Rob Hayward

being -0.42, and kurtosis -0.81. This shows that both investments would be plotted on a normal distribution graph
relatively similarly, with the hedge fund being slightly more central and slightly less flat. However as all figures are
negative, the graphs would not have any drastic differences, making the comparison for the two investments
difficult using skewness and kurtosis.
Another method for comparing the two investments is the Sharpe ratio. This is used to calculate risk adjusted
return, which could be used to decide whether the investment is worthwhile. For the hedge fund, the Sharpe ratio is
2.08, and for the index, it is 6.58. As the index is much higher it signifies that it is likely to give a greater return than
the hedge fund, making it the better investment. However, an investment choice cannot be made purely from this
method as there are problems with it, such as the fact that there is a reliance on the theory that risk is equal to
volatility, and that the volatility is bad.

Price over time comparison

It is also possible to make a graph using the data that has been compiled to help to assess the performance of the
potential investment over time. The graph for the hedge fund price is shown below.

Hedge Fund Price

3000

2500

2000

1500

1000

500

As you can see, this graph shows that the hedge fund price has risen relatively consistently since 1997. There are no
major drops in the price throughout the graph. The only notable drop is in 2007, around the time of the financial
crisis, which caused a drop in nearly every investment. This graph can be seen as a positive performance making the
investment in the hedge fund relatively appealing depending on how long the investment is for.

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Thomas Newcombe

Finance and Investment

Rob Hayward

The graph for the price over time of the index is shown below.

Ftse 100 Monthly from 1997

8000
7000
6000
5000
4000
3000
2000
1000

As you can see, this graph fluctuates much more than the hedge fund, potentially making it riskier. There are two
noticeable drops on the graph, the first being a gradual drop from 1999 to 2002, and the second being a more
sudden drop in 2007 and 2008, caused by the financial crisis. From this graph, an investment in this would not be a
good choice as there has not been a large rise over time, only the occasional peak.

Conclusion
In conclusion, from the data collated and presented in this report, and the calculations made, it is safe to assume
that the investment with thigh highest potential returns is in the hedge fund, as it has performed much better over
time and is more normally distributed. However, there is a problem that the data collected on the hedge fund is not
as accurate as the data for the stock index, meaning that the calculations, and the price over time graph could be
wrong and leave out possible falls. The correlation between these two data sets was calculated at 0.3, meaning that
there are similarities between the price changes of the two investments, and as both the hedge fund and the stock
index have risen over time, both could be seen as possible investment choices.

Appendix
All data was collected using the following websites:
https://uk.finance.yahoo.com/
http://www.barclayhedge.com/

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