The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (5 page)

Coming of Age through a Crisis

The summer before starting Harvard Business School in 1971, Dalio clerked on the floor of the New York Stock Exchange. During that summer, the Bretton Woods system broke down, and it left an indelible impression on him.

“It was one of the most dramatic economic events ever,” says Dalio, “a very, very big deal and I was at the epicenter of it on the floor of the New York Stock Exchange. It thrilled me.” Dalio remembers President Nixon making a nationally televised address on a Sunday night. “He was spinning political speak, but what he was saying was that the U.S. has defaulted on its debts. And it got me thinking about what money is. What are dollars if they are not tied to gold?”

Recognizing that the currency crisis was now driving all other market behaviors, Dalio delved into a study of the currency markets. He began to pay attention to Paul Volcker, now a friend and adviser, then the Treasury Department’s Undersecretary for Monetary Affairs. He began reading all the public statements, then tried to reconcile them with reality. “I saw how the government lied or certainly spun things in a certain way. I had all these philosophical questions, like Whom do you believe? What is actually truthfully going on? All of this pulled me into global macro markets. The currency markets would be important to me for the rest of my life.”

At business school, Dalio was like a duck in water, as he likes to say. He felt he had climbed to the top of the academic heap and would be learning with the best of the best. Harvard’s case study method excited him because it allowed students to have the freedom to lead with their own thinking. There was very little classic teaching or memorization, techniques Dalio had resisted for so long. Dalio felt, at long last, he had found his ideal environment. “Basically, all you were given was the description of the case and a situation. It was up to us to decide what was important. There were no questions, let alone anyone telling you what to do. I always had this desire to talk about what’s true, and here was a process where there was a quality debate and discussion among smart people with different points of view. It was not left-brain learning. It was right-brain learning in the sense that you’re learning through the experience. It was so exciting.”

Dalio would eventually take this learning method with him when he formed Bridgewater, where he, above all, encourages the search for truth and excellence.

In 1972, the summer between Dalio’s two years at business school, he decided he wanted to learn more about the world of trading commodities, and he convinced the director of commodities at Merrill Lynch to give him a shot. Because of commodities’ low margin requirements and, at that time, relative obscurity, Dalio figured he was likely to be successful and make money. He was wrong. “I hardly made any money,” he says, recalling his summer as an assistant at Merrill, “but I remember I loved it. And that was great. Even back then, I was never really concerned with money past a certain point of utility. I was happy sleeping on a cot in a studio apartment. All I cared about was having the freedom to do what I wanted to do.”

As luck would have it, Dalio’s return to Harvard coincided with a huge surge of inflation. The breakdown of the monetary system in 1971 had caused a surge that pushed commodity prices higher and created the first oil shock in 1973. To combat inflation, the Federal Reserve tightened monetary policy, which brought on what until then was the worst bear market since the Great Depression. All of a sudden, there was a rush into previously unfashionable commodities futures trading, and brokerage houses clamored to build new trading departments. Because Dalio had experience trading commodities, had worked for the commodity division head at Merrill Lynch the previous summer, and had a Harvard MBA, he immediately got a job as the director of commodities at a midsize brokerage and was tasked with setting up the new division. When the brokerage house folded, Dalio moved to Shearson Hayden Stone, the brokerage firm run by Sanford Weill.

At Shearson, Dalio was in charge of the institutional/hedging business, advising clients on how to hedge their business risks. He did not last long. He was fired, he says, shortly after having a drunken argument with his boss on New Year’s Eve in 1974. Dalio decided to strike out on his own. He was 26 years old.

Building Bridgewater

Ringing in 1974 on a positive note, Dalio set up shop in his two-bedroom apartment on East 64th Street in Manhattan on New Year’s Day. He had been trading the markets since he was 12 years old and had planned to continue doing so as he developed his outfit. It seemed the stars had aligned—he already had incorporated the name “Bridgewater” for an association he had cofounded with some former Harvard Business School classmates. They wanted a generic name that made sense for a physical commodities import business. Though that business didn’t take off, the “boring” name they chose would last for quite a while.

Dalio was never afraid to dive into unfamiliar territory. “I think ego stands in the way of a lot of people doing that. It’s like learning how to ski. . . . The sting of the fall hurts for about a minute but that’s how you learn.” So he pored over as many annual reports as he could get his hands on. He didn’t know they contained income statements, balance sheets, or cash flow statements. As he started studying, he began to ask himself a lot of questions. “And questions lead the way,” he says.

From the start, Dalio never built Bridgewater to draw in investors. Instead, he wanted to focus on managing exposures, writing research, and continuing the pursuit of truth and excellence while he continued to study currency and commodities markets. He remembers being calm and pragmatic about the new venture. “I didn’t really feel any anxiety about starting out on my own,” says Dalio. “I could pay the rent. I had free time to do what I wanted—I liked the independence. And so I thought if it didn’t work out, I’d go get a job. And if it did work out, then I’m home free.”

He also thought he had the right personality to handle the pressure. “I think anybody who is a great investor, a good investor, a successful investor has to be a person who can be both aggressive and defensive, too. You have to be able to bet. But you also have to have enough fear to have the caution. But you can’t let the fear control you.”

Dalio found opportunity in the many large institutions that had exposure in different commodities as well as interest rates and currencies. Currencies, interest rates, and commodities were the things he understood. “There were a bunch of institutional clients at Shearson,” he says, “who wanted to pay me for advice. Commodities were so volatile they needed direction.” So he began consulting and managing exposures for corporations and institutional hedgers, and collecting his thoughts and observations in a kind of client letter called
Daily Observations
. “Because of my derivatives background, I traded commodities, which became various futures, which evolved into swaps and derivatives. I got evolved. I could separate things in a way that was unique.”

Winning Over the World Bank

Dalio soon built a reputation for quality macro research. His
Daily Observations
became a critical touchstone not only for Bridgewater’s clients but, from the early 1980s onward, became so widely read that they rivaled other firms’ annual reports and are at least more popular, if not more influential. They became required reading for corporate executives, policy makers, and central bankers around the world.

One such reader was McDonald’s. When the fast food giant invented the Chicken McNugget, they came to Dalio to help hedge chicken prices after reading
Daily Observations
. “They came to me and said, ‘Look, we have all of this exposure. How do we protect ourselves so we don’t have to change the menu price of Chicken McNuggets all the time?’ I helped them through that.” Another such client was Nabisco, which needed to manage its interest rate currency and commodity risks. “But they would also give me authority,” says Dalio. “So when I say ‘managing,’ they’d give me a piece of the profits I created on top of the fees.”

Frequently these days, Dalio’s
Daily Observations
lead to discussions with policy makers and clients. Dalio doesn’t reveal the timing of transactions or what banks he is trading with. He says, “I don’t want to disclose things pertaining to what positions we’re going into and why. So I’m just describing what I think in those
Daily Observations
, which is pretty open.”

Bridgewater evolved from corporate consultant to money manager in 1985, when the officials of the World Bank, after reading
Daily Observations
religiously for several years, approached Dalio with a $5 million test portfolio of domestic bonds to manage. For the first few years Bridgewater managed the accounts by creating a benchmark portfolio, as any manager would. That would be the neutral position. Then it would take deviations from the benchmark because there are always two portfolios—alpha and the benchmark replication (beta). Dalio knew that in order to protect downside risk and promote alpha generation, he’d need to convince the World Bank to let him transition from traditional asset management practices, where a portfolio manager would peg his hedges and positions to a benchmark, to an active manager that could take a variety of alpha positions around the benchmark. “I always wanted diversified alpha. So I encouraged the World Bank to give me greater leeway, saying there’s no reason you should be giving me a domestic bond account because you’re getting much less diversification.”

Bridgewater pursued a similar strategy in currency markets—managing “hedge portfolios” for clients based on their international equity exposure, but then deviating from that hedge portfolio in all currency markets. For example, a U.S. client could own a portfolio of European equities and hire Bridgewater to hedge his euro/U.S. dollar exposure, and, to add value, Bridgewater would trade all the major currency pairs globally long and short. By building an active portfolio that was fully diversified and free of systematic biases (no tendency to be long or short), Dalio felt the firm would be better suited to add value consistently and regardless of the particular market environment.

Driven by Dalio’s hunger for innovation and his passion for truth and excellence, Bridgewater moved forward. Eschewing retail investors, Dalio preferred to work with institutions. “I like to deal with people who are thoughtful and I can have quality communications with,” he explains. He likes clients who don’t simply put blind faith in the firm, but want to engage in a good dialogue, and then give their manager the freedom to execute. “Somebody said to us, ‘Never have a stupid client.’ And so why not manage money for clients who give you $300 million or $500 million and are smart?”

In 1991, Bridgewater set up its flagship Pure Alpha strategy. Pure Alpha traded global bond markets, currencies, equities, commodities, and emerging market debt. At any point in time, it would combine these 60 to 100 positions with any client-chosen benchmark. For the Kodak pension fund, an early client, Bridgewater managed Pure Alpha combined with a passive holding in long-duration bonds and inflation-indexed bonds. It was the best way to produce the best risk return. “Now it would be called innovative,” says Dalio. “Back then I guess it would be called crazy.” By doing this, the client could always specify beta.

“This is how we manage money now,” says Dalio. “Clients tell us they would like an equity account and set a benchmark, like the S&P 500. We either replicate the benchmark or buy futures to equal the benchmark. After they put money into Pure Alpha, it’s overlaid on that benchmark. So Pure Alpha is just our best mix of alphas, calibrated at 12 or 18 percent volatility, depending on the leverage they’d like.”

Dalio likens it to a two-column Chinese menu: choose your beta from column A and your alpha from column B. “We probably have 40 different benchmarks that the client can choose from,” he says. “How spicy do you like the alpha? If you want 6 percent volatility, you just put half the money in the 12 percent fund. If you want 18 percent volatility, you put 100 percent of your money in the 18 percent fund. If you want 1.8 percent volatility, you just take 10 percent of your money and put it into the 18 percent fund. It’s our best mix of alphas applied to every account we manage,” says Dalio.

After a year or two of tracking performance and seeing that they had all performed as predicted, investors became more accepting of the notion of separating alpha and beta and of putting that together in the fund. “We did it simply for functional reasons,” says Dalio, “and lo and behold the world calls it a hedge fund.”

Belly Up: Learning from the Bad

There were also rough times at Bridgewater, but all proved great learning experiences for Dalio and his team. His most painful experience was trading pork bellies in his personal account in the early 1970s. Because hard commodities had stop limits, if the commodity hit a certain price of “limit,” it would stop trading for the day. During one dark week, pork bellies traded down further and further, causing them to hit their daily limit price day after day and forcing Dalio to stay in the position. He ended up losing “damn near everything.”

“It was great in that it was terrible,” says Dalio, reiterating that you always learn more from the bad experiences in your life than the good. “It was a fantastic learning experience.”