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Comment by ProjectArcturis | Hacker News Reader

Well, that, but they also offer diversification. In general they will return lower average gains than the stock market, but they are often uncorrelated with it. Adding them to a portfolio can raise its Sharpe ratio (mean return divided by standard deviation of returns).

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> Well, that, but they also offer diversification. [...] > are often uncorrelated [...]

Do they really offer diversification and are they really uncorrelated? See http://universa.net/Universa_Spitznagel_SafeHaven_HedgeFunds...

I particularly like this quote as a summary:

> Hedge funds would appear to have lost whatever ability they may have once had to provide risk mitigation value (which, let’s face it, wasn’t very much). Hedge funds just don’t effectively hedge anything; worse yet, perhaps they have even lost sight of that very objective in the first place. They are without a purpose.

"Hedge funds" encompasses an enormous variety of investment strategies. There are certainly some that create uncorrelated alpha. There are others that are basically large cap index funds. And still others that are trading on signals which contain no actual edge at all.

The Sharpe numerator is excess return, not mean return.

Can you also explain why a hedge fund portfolio would increase your portfolio’s Sharpe ratio? Already with the returns in the article it’s less than S&P500 so it’s likely somewhere below the CML as the efficient frontier.

Okay, the risk-free rate had been zero for so long that excess return was essentially equal to mean return.

That nit picked, the addition of any source of return greater than the risk-free rate, if uncorrelated to the rest of the portfolio, will improve Sharpe. If the return is small, then the optimal allocation is small as well, but still nonzero.

In CML terms, the existence of hedge funds as uncorrelated strategies changes the shape of the CML curve.

A low covariance with the rest of the portfolio will lower the denominator. As long as E(r) is higher than r_f, it’s possible to end up with a higher sharpe. Obv just leverage if you want a higher expected return.

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