Thread by @breakingthemark

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.

breakingthemarket.com/optimal-portfo….

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.