The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (6 page)

Bridgewater also took a hit on missteps investing in sovereign bond markets, a position it sold off after the surprise Fed tightening in 1994. The firm was long various global bond markets, and, when the Fed tightened, they all became correlated to each other and lost money. Ultimately, the fund returned 2 percent that year but acquired something of far greater value: a better procedure and strategy going forward.

“We learned that if you had the same positions in a variety of countries, that you could take our relative views in each country and trade those on a duration-neutral spread basis,” says Dalio. “By doing so they would systematically guarantee the fact that we wouldn’t have correlations to the broader market. So what we did was we discovered essentially how to restructure the balancing of our positions to produce greater diversification. That carried forward into all the markets we traded.”

Bridgewater made a further step toward the separation of alpha and beta when, in 2006, it stopped managing traditionally constructed global bond and currency accounts. From its first experiment separating alpha and beta for its clients in 1990, Bridgewater had found it was the best way to manage money. Its method is to take a value-added return from active management (alpha) minus the return from passively holding a portfolio (beta) and create optimal portfolios for each where clients specify their desired targeted level of risk. Bridgewater called its first optimal alpha strategy Pure Alpha, and it would be an integral step in the process for every investment made across the fund.

So, toward the end of the 2006 Bridgewater sent letters to clients about the “constrained” nature of those alpha-generating strategies, which didn’t permit the firm to move freely among asset classes. Bridgewater announced that henceforth clients would use Pure Alpha in conjunction with its bond or currency accounts; those unwilling to make the transfer would be resigned within 12 months. Once among the largest traditional global bond and currency managers in the world, Bridgewater today uses Pure Alpha only in conjunction with its actively managed accounts. While some would find this risky, Dalio maintains it is a better way to manage money and reduce the risk of underperformance for clients and the firm.

At the same time Dalio was finding ways of being uncorrelated to the market, he was making the discovery that other firms were becoming increasingly correlated to the market. Bridgewater wrote to investors in 2003 that hedge funds in aggregate were over 90 percent correlated to the equity market and that, within substyles, the managers were all highly correlated to each other. “The basic point here is that many hedge funds have a lot of beta (systematic risk) embedded in their strategies and returns. Investors investing in hedge funds need to consider the implications of these systematic risks in the hedge funds they are invested in.”

Sage advice from Dalio that would be realized in the 2008 financial crisis when 90 percent of hedge funds lost money and did not provide the downside protection or absolute returns.

Calculating Crises

“I think it would probably be a good idea to show you something called our crisis indicator,” says Dalio one bright spring afternoon at the firm’s retreat-like offices. Designed by noted architect Bruce Campbell Graham, the campus has three buildings constructed mostly of glass and midcentury fieldstone. The firm moved to Westport in 1990, and, like its corporate culture and hierarchy, the buildings are mostly flat and the spaces meticulously organized. Employees park their cars between the trees of the small forest across from the entrance, and lights hang from the branches. Once a natural reserve filled with large lakes, there is a serene ambience to Dalio’s inner sanctum. Somewhat contradictory to its placid work environment, however, the Bridgewater team is awfully focused on crisis.

Dalio creates universal investment and management principles by learning from history. He analyzes how different countries, cultures, and people around the world react to different incidents like debt or oil shocks, for example, and figures out the variables that affected the different outcomes. Stripping away all the variables let Bridgewater arrive at universal laws for doing business. “If you’re limiting yourself to what you experienced, you are going to be in trouble. . . . I studied the Great Depression. I studied the Weimar Republic. I studied important events that didn’t happen to me.”

Doing this over time led Bridgewater to develop ideas such as its crisis indicator. The crisis indicator looks at each of the major markets to show their correlation to overall market risk, which is part of the reason Bridgewater has always historically kept its leverage low by industry standards, about three to four times assets over equity over the life of the firm. By comparison, Lehman Brothers was more than 40 times leveraged before its collapse in 2008. In fact, Dalio believes that its limited use of leverage is one of the main reasons the firm has survived for more than 30 years. “Using leverage is like playing Russian roulette. It means that you are inevitably going to get a bullet in the head.”

Dalio explains, “As risk at a particular period of time increases or decreases, it is either going to have a positive or a negative effect on certain markets and in various magnitudes.” For example, when dealing with bad economic conditions and higher default risks, Treasury bonds would have a positive beta, and equities would have a negative beta. And each instrument has various betas to it. “You can go back to Argentine stocks and certain emerging currencies,” Dalio says. “They all have various betas that we can see and adjust according to changes in the global risk environment. As a result, we pay attention to those things in structuring the portfolio. It’s a computer system that’s constantly updated.”

Foreseeing the Financial Crisis

It was the constant economic monitoring and fund evolution that led Dalio to the conclusion in 2006 that the American economy would be heading toward a bankruptcy-like situation, one where debt-service payments would rise relative to income, and the government would be forced to print tons of money and buy long-term assets. As a precaution, he and his team studied Japan’s “lost decade” and the Latin American debt crisis of the 1980s, and, as a result of their findings, the firm’s traders piled into those investments that would be least affected: U.S. Treasury bonds, gold, and the yen.

The first big payoff for Bridgewater’s “D-process” (research on deleveragings and financial crises) came in the spring of 2008. The risk metric for credit-default spreads clicked on, triggering Bridgewater to exit its entire position in several banks like Lehman Brothers and Bear Stearns (the week before Bear Stearns imploded). While most funds were down close to 20 percent that year, Bridgewater’s process led the fund to positions that weren’t tied to the performance of the stock market. Bridgewater was able to segregate risky investments, safer investments, and degrees of risk, causing the fund to clock in a 12 percent gain by the end of the year.

Being able to measure the degree of riskiness of assets in the portfolios by separating their betas helped influence the firm’s positioning in 2008. To help clients better comprehend what was going on, Dalio penned a 20-page explanation of how the economy works called “A Template for Understanding What’s Going On” that Bridgewater included in its 2008 annual report to investors.

Another input factored into Bridgewater’s models: eight years before the financial crisis, the firm put in place a depression gauge. Because it had studied the nature of deleveragings or depressions, the team knew that deleveragings occur when interest rates go to zero and there’s an excessive amount of debt. In January 2008, Dalio forewarned of the dangers of overreliance on tools like historical models during an interview with the
Financial Times
.

“What is the most common mistake of investors?” he warned. “It is believing that things that worked in the past will continue to work and leveraging up to be on it. Nowadays, with the computer, it is easy to identify what would have worked and, with financial engineering, to create overoptimized strategies. I believe we are entering a period that will not be consistent with the back-testing, and problems will arise. When that dynamic exists and there’s close to zero interest rate, we knew that the ability of the central bank to ease monetary policy is limited.”

When Dalio looks at the world today, he sees it divided into two parts—debtor-developed deficit countries and emerging market creditor countries. He further breaks it down into countries that have independent currency policies, and those whose currency and interest rate policies are linked. Dalio believes that countries like the United States and England that can print their own money are in much less trouble than countries like Spain that don’t have independent monetary policy and have currency links. “You have a debt problem and can’t print money—a terrible situation that’s going to get worse.”

On the other side of the spectrum, a creditor country that can’t print its money and doesn’t have independent monetary policy, such as China, is going to suffer from imported inflation. Dalio explains that debtors can’t ease enough and creditors can’t tighten enough. In the next 10 years or so, Dalio expects a major currency breakup over tensions between the United States and China. Because it will be increasingly hard for countries like the United States to fund their deficits, we’ll see a decreasing willingness of foreign investors to invest in these countries. He predicts the symbiotic relationship between China and the United States, in which the dollar is dominant, will end.

As a result, Dalio is interested in emerging markets’ currencies. “As [countries are] experiencing higher levels of inflation and they’re tightening monetary policy,” he says, “it’s going to be harmful for the bond and beneficial for the currencies.” Dalio also feels the currency appreciation will hurt equities because appreciation makes a company less competitive in the world and the asset prices measured in its own currency go up along with the currency. “So it’s particularly those emerging market currencies in countries that are large creditor countries,” Dalio says, “which are running still large surpluses and that are overheating.”

Extracting Alpha

In March 2010, after walking on stage to accept the Lifetime Achievement Award from Alternative Investment News, Dalio projected the future of the hedge fund sector—and it wasn’t good. The tragedy, he explained, was that the average hedge fund is still about 90 percent correlated with equities.

“The industry is severely belying its central purpose by being persistently exposed to too much beta,” stated Dalio. “By eliminating the beta in their portfolios, hedge funds would inevitably become more attractive to large pools of institutional capital.” Deemed the world’s first institutionalized hedge fund, with 300 clients, Bridgewater is known for accepting capital only from large pension funds, endowments, central banks, and governments.

Dalio believes that the issue of not having any systematic bias is a big thing. In other words, there’s no good reason there should be a bad or good environment for hedge funds—they shouldn’t have any beta—period. “There’s an equal opportunity up or down in any kind of environment,” says Dalio. “There should be just the alpha, and that is important in terms of what the role of hedge funds is and for portfolio diversification.”

By the end of 2010, Bridgewater reported its best year ever, increasing assets by $15.3 billion and earning about $3 billion for Dalio personally. The flagship Pure Alpha Fund II returned 44.8 percent, and the firm as a whole made more money for its investors than the 2010 profits for Google, Yahoo!, Amazon, and eBay combined. In 2011, the Pure Alpha Fund II returned 25.4 percent, bringing its cumulative gains for investors to nearly $50 billion—more than any other hedge fund.

From its first experiment separating alpha and beta for its clients in 1990, Bridgewater found it was the best way to manage money. Its method is to take a value-added return from active management (alpha) minus the return from passively holding a portfolio (beta) and create optimal portfolios for each where clients specify their desired targeted level of risk. Bridgewater called its first optimal alpha strategy Pure Alpha, and it would be an integral step in the process for every investment made across the fund.

Bringing Home the Alpha

To generate alpha, Bridgewater follows a fundamental and systematic investment process. It uses analysis of past events to help stress-test its thinking of how markets work, using over 100 million data series that extend across developed and emerging countries, and in some cases back 100 years or more. Once the criteria are proven to be sound, they can be processed instantly to stay on top of market developments.

Dalio explains the process this way: “What we’re basically doing is that there are individual concepts that are being multiplied in a number of cases—it’s not like there are 100 million independent observations,” says Dalio. Once the criteria are established, the work of engineering a portfolio begins. The criteria can be applied in 100 million cases or a single case. Broken down, the process allows the firm to better understand what is going on. “There’s information management that allows me to do quality fundamental analysis through my computerization,” says Dalio, “really high quality analysis that has a large sample size. And that large sample size allows me to produce a lot of uncorrelated bets.”