Ray Dalio founded Bridgewater associates, the largest hedge fund in the world, he is a self-made-man and billionaire. We explore his investment strategy.
Bridgewater Associates is having a poor 2020 so far and last year (a banner year for stock markets) its main ‘Pure Alpha’ fund lost money for the first time since the year 2000.
Naturally, some are beginning to ask if Ray has lost his touch…
So here we aim to ask two questions-
1. What is Ray Dalio’s strategy? AND
2. Why isn’t it working in 2019 and 2020?
What is the Bridgewater investment strategy?
Ray Dalio and Bridgewater have pioneered various investment strategies - and even advised the US government on the adoption of inflation-indexed bonds.
Broadly speaking Ray Dalio is ‘macro investor’. That means he makes his investment based on a view about the economy. That is opposed to, for example being a stock picker, i.e. somebody who chooses companies to investment in.
Bridgewater has two main investing strategies, which have taken the form of its main funds - the ‘Pure Alpha’ and the ‘All Weather’. In order of chronology:
1. Pure Alpha
Pure Alpha makes directional bets on various markets including stocks, bonds, commodities and currencies by predicting macroeconomic trends with the help of computer models and algorithms.
This same description can be applied to many modern-day ‘macro’ hedge funds but Ray Dalio was one of the first to strongly adopt computer modelling to verify his ideas about the way the economy functions and asset prices respond.
An example trade might be on the exchange rate between the US dollar and the Japanese yen. Based on his team’s belief that interest rates in the United States will rise faster than in Japan, Bridgewater might take a long position in USD/JPY in the spot forex market or in currency futures.
Dalio has since famously created the below YouTube video to explain his concept of the ‘economic machine’ that is the foundation of the Pure Alpha bets. The video breaks down economic concepts like credit, deficits and interest rates, allowing viewers to learn the basic driving forces behind the economy, how economic policies work and why economic cycles occur.
2. All Weather
This is the granddaddy of ‘risk parity’ (or ‘balanced beta’) investing. The concept is to allocate assets within the portfolio in a more balanced way in order to balance risk.
So rather than making directional bets like the Pure Alpha strategy, All Weather is an active asset allocation strategy. Bridgewater will adjust the weighting of its portfolio in different asset classes depending on the economic environment but the idea is that it can survive in any environment.
Bob Prince Co-CIO with Ray Dalio at Bridgewater explains the difference with traditional portfolio construction:
The traditional approach to asset allocation tolerates higher short-term risk through a concentration of risk in equities in order to generate higher longer-term returns.”
He adds: “The long-term risk of holding a portfolio that is concentrated in equities, or in any other asset for that matter, is much greater than most investors realize and, in reality, too great for them to bear.”
To paraphrase Bob, Bridgewater doesn’t adhere to the ‘buy and hold’ idea that over the long term stock markets always go up and will give you a higher risk-adjusted return than other investments like government bonds or money market funds.
Rather than being like traditional pension funds that put 90% of the portfolio into equities, or even the 60/40 balanced portfolio - the All Weather fund changes the balance among equities, bonds, currencies and commodities according to the risk of each asset class and the economic environment.
Bridgewater funds are only open to large institutional investors but self-help guru Tony Robbins asked for Ray Dalio’s help in constructing a simple version of the All-Weather funds using ETFs and other widely available investing products that any investor can replicate - and it looks as follows:
Dalio describes four different “seasons” that can effect the value of asset prices.
• Higher than expected inflation (rising prices).
• Lower than expected inflation (or deflation).
• Higher than expected economic growth.
• Lower than expected economic growth.
The idea is that having all of these assets in these weightings, the well-balanced portfolio can weather all seasons.
Dalio’s Holy Grail: Diversification & Correlation
Ray Dalio describes his guiding concept behind his investing is as making use of diversification with uncorrelated assets to lower the amount of risk he takes to make a certain return. His idea is to find “15 or 20 good uncorrelated return streams.”
Dalio told Investopedia that
“A lot of people think the most important thing you can do is find the best investments, that’s important but there is no great best one investment."
Adding “You can improve your return to risk: ratio by a factor of five.. you can’t pick any investments that are five times as good individually.”
The following chart from Bridgewater visualises this concept of contrasting expected return, risk and the number of assets with specific levels of correlation.
Sounds good, what happened?
In a sentence, the coronavirus and a stock market boom.
Dalio told the Financial Times that
"We did not know how to navigate the virus and chose not to because we didn't think we had an edge in trading it… so, we stayed in our positions and in retrospect we should have cut all risk."
In essence, Dalio’s ‘economic machine’ was thrown out of the window when the pandemic arrived because nothing like it has ever happened before. The economic models and algorithms for the economy that Bridgewater uses to make its investment decisions had no ‘virus’ input so the outputs produced no useful result.
In a different way, the All Weather portfolio is suffering similar problems to last year. 2019 was a banner year for the stock market. The S&P 500, America’s benchmark stock index rose 28.9% in its biggest one-year gain since 2013. This year equities plummeted in March but subsequently rallied thanks to a combination of central bank and government stimulus and supercharged retail trading activity.
2019 and 2020 (so far) were years when it paid to be heavily overweight equities, unlike the All Weather portfolio that is specifically designed to reduce the risk of putting too many of your eggs in the equity basket.
Bridgewater will likely not be the biggest hedge fund forever and a new investing legend will be born to dethrone Ray Dalio. BUT after 40 years of out-performance, it is likely too early to write him off because of the last two years.
The influence of macro economics will reassert itself over markets from the coronavirus and every bull market in stocks must come to an end - and that could be Ray’s time to shine again.
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