The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (7 page)

The skill comes into play with structuring and engineering a portfolio of bets. “To create the proper balance and diversification is even more important than any particular bets,” says Dalio, “which is the opposite of how most investors operate.”

Dalio deems this critically important: engineering his data series to produce as many uncorrelated bets as possible. He is constantly analyzing the spreads between any two markets in his portfolio that may generate the highest possible alpha, or, in other words, a return series.

Dalio says if you have 15 or more good, uncorrelated bets, you will improve your return to risk ratio by a factor of five. He calls this the holy grail of investing. “If you can do this thing successfully, you will make a fortune,” he says. “You’ll get the pot of gold at the end of the rainbow.”

He sets a simple example: say an investor has 15 bets and they all have an expected return of 3 percent, with a standard deviation of 10 percent, and they’re uncorrelated. And so you have one with a 3 percent expected return and a 10 percent standard deviation. And then the investor throws into the mix a second bet that also has a 3 percent return and 10 percent standard deviation but uncorrelated, thereby reducing the overall risk by about 15 percent. If the investor does that with 15 different bets, they reduce the risk by about 80 percent. Such a portfolio would still have a 3 percent expected return. But because there are still 15 uncorrelated bets outstanding, that 3 percent expected return now has only a little over 2 percent risk. That 3 percent can now be leveraged to meet the investors’ return target with far less risk.

Dalio estimates that if the firm can make money on 60 to 65 percent of its bets in any given year, the odds are very high that the fund will meet its return targets. In 2010, as the D-process continued to unfold, about 80 percent of Dalio’s bets made money.

Bridgewater sees endless opportunities to do this because spreads are uncorrelated. In doing this, the most important rule is not to compare the correlations against each other in a quantitative sense, but according to
their drivers
.

“But the truth is, as you get to 15 or 20 you start to reach diminishing returns,” says Dalio. “So the issue is, ‘Do you really know what you’re doing? Can you be confident it’s good?’ I used the word
good
. I didn’t use
excellent
. Can I be confident it’s good?”

Dalio thinks the best mix of assets is an amalgam of things, and advises to derive your top alpha generators from a combination of currencies, bonds, commodities, stocks, and so on, and calibrate them properly against each other, in terms of their size. For example, Bridgewater has never had a concentrated exposure to the U.S. dollar. It has always strived for diversification beyond what’s needed for liquidity. After the position has been weighted accordingly, the goal is to create an optimal beta portfolio of positions, know how they behave, how they’re structured, and how they’re priced. Then Bridgewater does that for every single position—the firm has about 100 uncorrelated alpha streams in its alpha portfolio at any given time.

Perhaps the most important application of this portfolio engineering has nothing to do with the firm’s Pure Alpha strategy. In 1994, faced with his own portfolio management decisions, Dalio created the “All Weather portfolio”—a passive asset allocation that was designed to take full advantage of diversification. “In the mid-90s I started to accumulate some money that I wanted to use to establish a family trust, and for that trust I wanted the right asset allocation mix,” he recalls. “That’s when I created the All Weather portfolio, which now accounts for virtually all of that family trust money.”

In 2001, following the equity market crash, Britt Harris, CIO of the Verizon pension fund, would become Bridgewater’s first institutional client to use All Weather. And in 2004, recognizing the need for the asset management industry to adopt the principles of separating alpha and beta, Dalio published a piece entitled “Engineering Targeted Returns and Risks,” which would show investors how to use the concepts he had used for many years in Pure Alpha and All Weather. Dalio called it “Post-Modern Portfolio Theory (PMPT)” because it built on the concepts of portfolio theory, but went a few steps beyond.

Regarding All Weather, Dalio wrote, “I believe that, as this approach is increasingly adopted, it will have a radical beneficial impact on asset allocation that will be of a similar magnitude to that of traditional portfolio theory as it gained acceptance.” Indeed, following the stress test of the 2008 financial crisis when most investor portfolios were down 40 percent into the stock market bottom, an All Weather portfolio was down less than 10 percent. Over its lifetime, it has outperformed the conventional 60/40 stock/bond asset allocation with only half the risk.

Seeing the potential for such a strategy, other money managers quickly sought to replicate the passive All Weather approach, and the industry adopted the name “Risk Parity” for such approaches. Over the past five years, managers such as AQR, First Quadrant, Invesco, Putnam, and Wellington began offering Risk Parity products modeled after All Weather. And in 2011, a survey of institutional investors showed that 85 percent were familiar with the approach and 50 percent were using or considering using the concepts in their own portfolios.

So, as a funding crisis looms for global pension funds and the adoption of Risk Parity accelerates, Dalio’s greatest impact on the investment industry is likely his invention of All Weather.

Fund in Focus

The founder of the world’s largest hedge fund is not its ruler but rather the reigning mentor. Greg Jensen, Eileen Murray, and David McCormick, the former undersecretary of the Treasury Department, are Bridgewater’s co-CEOs. Dalio had been the fourth co-CEO, but stepped down in July 2011 to take an advisory role. Though his vision, principles, and process emanate from every noteworthy decision the firm makes, he is adamant about the division of power between the executives. In addition to co-CEOs, the firm has co-chief investment officers in Bob Prince, Jensen, and Dalio. Bridgewater’s success goes beyond just Dalio, he says.

The firm’s funds are divided into Pure Alpha, the flagship hedge fund with $60 billion as of December 31, 2011; the $45 billion All Weather Risk Parity strategy; a portfolio of equally balanced assets that perform well in environments of rising growth (e.g., equities), falling growth (e.g., nominal bonds), and rising and falling inflation and the fund’s $15 billion Pure Alpha Major Markets fund, which launched with more than $10 billion in 2010, giving investors the option to reinvest their gains from that fund into a new vehicle. The firm’s flagship fund has lost money in only one year and only had a negative net of fees return in three years since its founding and boasts an average annualized return of 18 percent since 1991.

Though the funds are divided in a clear manner, Bridgewater’s structure is quite complex. The journey
is
the process at Bridgewater, and it often takes a good deal of back-and-forth before decisions are finalized. Perhaps even more importantly, a high degree of personal reflection is required throughout the process. As Dalio continues to build Bridgewater into a thriving organization, attracting the world’s most powerful clients, he is hit with a profound observation: the separation of alpha from beta, now a strategy synonymous with the hedge fund industry, was born at Bridgewater in 1990. The fund was also the first currency overlay manager and originated the idea of the popular Risk Parity strategy over 15 years ago. “From a business point of view, everybody told me each time that I was crazy because the thing wouldn’t sell,” says Dalio. “I would say I don’t care if it sells.”

All these inventions stemmed from innovative, independent thinking and focus on process. The process and subsequent reflection also helped taper the unruly emotion that can come along with investing. When asked about how he handles separating emotions from tough investment decisions, Dalio replies, “I think there were two ways: experience and meditation. I also found it very helpful to make systematic decisions.” Key to his investment process is writing down why he makes each decision so that after he closes the trade, he enhances his learning by comparing what happened to why he made the decision. What he did right and what went wrong.

Procuring the Principles

Dalio began to write his
Principles
—roughly 200 life, management, and investment guidelines—in the mid-2000s after observing that the employees at his growing firm were straying from the company’s basic tenets. He didn’t originally want to give out this “advice” but found that his friends and colleagues were struggling with issues that were all related to them, and he wanted to help.

Dalio says the principles for successful investing are the same as those for becoming a successful manager or leading a successful life. “You have to be assertive and open-minded at the same time. This is true in the markets; this is true in almost everything. You have to learn from your mistakes to keep getting better. And it’s through learning from those mistakes that you learn what reality is and how to deal with it, which is called principles. Knowing what’s true, whether you like it or not, is a tremendous asset. There’s no sense in fighting reality.”

The principles permeate everything Bridgewater does. Employees are encouraged to constantly ask themselves and their colleagues, “Is this true?” New hires are handed the text even before reporting for their first day of work on campus. Earlier this year, all employees were given iPads preloaded with
Principles
.

Dalio thinks it’s the fastest route to getting people where they want to be. “I learned that being totally truthful, especially about mistakes and weaknesses, led to a rapid rate of improvement and movement toward what I wanted,” Dalio says in the
Principles
.

Dalio has observed it takes about 18 months for a new employee to get used to the radical truth culture, and the firm publicly acknowledges that the culture is not for everyone. On its web site’s career page, Bridgewater asks potential applicants to ask themselves, before applying for a job there, if they want to: discover their strengths and weaknesses, work to get better fast, put aside ego barriers to learning, and demand others to be truthful and open and whether they are prepared to do the same. In Dalio’s
Principles
he supports this by saying, “There is nothing to fear from truth. Being truthful is essential to being an independent thinker and obtaining greater understanding of what is right.” That, in essence, is what Dalio hopes everyone that comes to Bridgewater will eventually learn.

Watchful Eye on the World Today

Dalio always keeps a watchful eye on all areas the firm is invested in, constantly in search of the next investment where it has been clear time has run out. For commodities, a sector he’s traded and studied for 40 years, a fundamental shift in demand may be near. Dalio recalls that many years ago there was the thought that if every Chinese had one more handkerchief, the world would run out of cotton. Now he fears it’s a reality. “I think the world right now is in the beginning of a tightening cycle,” says Dalio. “And it’s changing the way consumption occurs.”

Dalio feels that the world is structurally in a different environment today because of the shift in supply and demand balance due to the change in consumption. Dalio explains that the commodities universe encounters two cycles: the economic cycle, which affects demand, and the crop cycle. Another reason for this tightening is, as large-population countries raise their living standards, they raise their consumption levels. “So as we’re going ahead, I think that, from the overall demand cycle, the monetary policies in emerging countries are going to be slow to be adequately tightened,” says Dalio. “Generally speaking for extractive commodities, it will be a relatively bullish environment until this tightening cycle crosses the overall falloff in demand which, as I said, will be in 2012.”

Aside from gold, that is. Bridgewater has been long a large position in gold since it was $200 an ounce and plans to keep the position in place. Dalio doesn’t see gold the way other investors do as a tradable commodity, but rather as a currency hedge. “It serves the purpose of money. It was the original money. It can be used as a medium of exchange. You can move it around from place to place,” says Dalio. “Unlike a lot of commodities, it doesn’t have a big consumption element to it. It can be sliced up in little pieces like coins to be like money. And so it can serve that purpose.” For Dalio, it makes more sense to have the actual gold than to invest in the gold producers. “You can’t move around a producer like you can move around gold. And we’re in an environment in which there’s a question of what is the alternative to money.”

Dalio sees a real opportunity for institutional investors to better diversify using this “currency,” as he likes to call it, as a means to hedge. Dalio has observed that the assets most investors have the greatest exposure to are typically the worst assets because they are market-capitalization weighted. Moreover, they tend to have a lot of stocks and bonds that are particularly concentrated in the United States. “And so when you look at what percentage of a portfolio—either central banks’ reserves or institutional portfolios—are in assets like gold and emerging market currencies, you also see that they represent small percentages of those portfolios.” Dalio thinks that just the act of diversifying will improve portfolio returns. “So I believe that institutional investors can diversify their portfolios better by using gold as an effective means to hedge against risk. I think that you’ll see a continued movement in that direction.”