Hedge funds, are the spices of the investing world.

By themselves, they often don’t taste spectacular, but when you mix them with other ingredients they improve the flavor of other foods.
Many specialized funds do not actually produce much, if any, return. But they are often negatively correlated to the market.

This means that adding them to a foundational “beta” portfolio improves their geometric return by lowering portfolio volatility.
What bothers me though is spices have recipes, which tell you how much spice to add to what amount of the other main ingredients.

Hedge funds don’t. How much hedge fund do you mix with the S&P 500?
Mix too much, and you will harm your overall portfolio returns, just as you will ruin a dish if you add to much spice. Don’t add enough, and you can’t really taste the spice or see much benefit to returns.

The mixing ratios matter a lot.

Another issue is quantifying the benefit of these “spices”. How much better does the fund make the portfolio?

You can usually try food with spices to know the improvement, but it’s never clear with hedge funds how much they actually improve a portfolio.
And more importantly, do they improve the dish more than other ingredients, like just owning a few other diverse assets like bonds, and gold?

Maybe this information is given out to actual prospective clients but I doubt it.
My gut feeling is the benefit of these funds is small, if it exists at all. It’s better that they don’t publish a “combined portfolio returns” because then, it would be clear it’s not really much different than a leveraged 60/40 portfolio or a leverage permanent portfolio.
I have no doubt that some of the best ones really do improve portfolios. But from my experience, it’s very hard to improve a well diversified portfolio.

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More from @breakingthemark

15 Apr
I think the real scarce resource in Bitcoin isn’t created by the the 21 million coin limit, but by the 7 transactions per second limit.

The real money will be in controlling that resource.

A thought experiment...
Let’s assume Bitcoin is successful from a store value/digital gold perspective. People will use it like a savings account or investment account.

Suppose there are a billion wallets, a touch more than 10% of the global population (of course organizations will have wallets to).
Since bitcoin is for savings, imagine people only need to make a transaction once a month.

Invest new savings or pull out past savings to purchase something. Similar to what people use long term savings/investing accounts today.
Read 18 tweets
31 Jan
Some of the takes lately on short sellers have been exaggerations of reality in my opinion.

Short sellers serve an important roll in the markets. They dampen out volatility because they often cover when prices fall rapidly to cover their positions, and sell on rapid...
.., unusual price increases on the way up. Usually this improves market stability.

Others have pointed out they also ferret out fraudulent companies like Enron and Worldcom. All true.

Lately, I have seen the following companies being short squeezed described as frauds:

Read 11 tweets
17 Dec 20
I just re-read Bernoulli’s 1738 paper “Exposition of a New Theory on the Measurement of Risk” which is the foundational paper of Expected Utility Theory.

It’s Amazing

It’s so wildly different than EUT that its hard to believe this was its beginning.

Let’s see if you agree.
The paper isn't about utility. It’s about expected value.

Bernoulli used the utility concept to get the reader to abandon the traditional view of expected value(arithmetic average), and then used it to derive the equation for valuing risk.

The final equation doesn’t use utility
He starts out the paper identifying that tradition evaluation of risk come from expected values, which are calculated with the arithmetic average.

Notice the rule here in italics is about expected values.
Read 30 tweets
14 Dec 20
If everyone is society optimized for arithmetic return, or linear utility, then society would grow wonderfully at first. Society's geometric return would be high. Some people would win big, some would lose big, and the average would be good because many are involved.
Through time though, many people would get unlucky by losing a few times in row and would fall out of contributing because they don’t have much capital/resources/access any longer to help. So now the number of contributors to society’s growth is smaller.
If people keep basing decisions on linear utility, with fewer and fewer winners each round and more and more losers, a funny thing starts to happen. Probability says society stops growing as more people fall out of the game, leaving fewer people capable of creating growth.
Read 7 tweets
4 Jul 20
There are two side to the Kelly Criterion which I think often get equated as the same when they really are not.

Traditional Kelly betting is about limiting your exposure to a risky bet. The bet in question is usually a "bet" in that when you lose, you lose everything you expose.
So you scale back and don't risk everything. Most casino games fit this description as do some financial instruments like options.

The optimal leverage here is less than 1. You want to hold cash on the side to buffer the future losses.
But standard investment assets, don't work this way.

I showed here, that individual stocks are effectively full Kelly bets.

Just buying one stock is the appropriate "size", as they have an optimal leverage of 1.

Read 7 tweets
1 Jun 20
Lots of tail hedge articles these days. I feel many miss the point. They keep studying returns as if they add with each other through time. They don’t. The math of lose 3% in 9 calm years, make 25% in the one volatile year = -5% return is meaningless.
The average through time is meaningless because investment returns don’t ADD. They COMPOUND.

A tail hedge that reduce the average return of a portfolio (as a tail hedge often does) but reduces the portfolio variance by more than twice as much, leads to higher geometric returns.
Now is this really complicated and difficult to get right with options based tail risk hedges? Yes. There are so many ways to implement it and returns are skewed and convex. And if you don’t understand why tail hedges are useful, you could easily butcher the implementation.
Read 8 tweets

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