Bridgewater Associates, operating out of a 22 acre Westport, Connecticut campus and staffed with an army of over 1200 employees, is currently the largest hedge fund with an estimated 125 to 150 billion dollars assets under management.

The firm was founded by Ray Dalio out of his apartment in Manhattan in 1975 to provide consulting services to corporate clients. Initially, the firm advised corporations on how to manage their currency and commodity-exposure risks. Soon thereafter, as Dalio’s expertise in describing complex financial problems and insightful solutions in simple terms (e.g. his paper on a jeweler being described as a business long in gold that needs to hedge against his gold inventory) developed and shined through his institutional client’s boards, he started providing macro economic advise to giant corporations such as McDonalds and Nabisco, and also government agencies.

In the eighties, the firm began to regularly publish its insight in a newsletter entitled Daily Observations. This was a paid subscription and till today is sought after and read by major corporate C-level decision makers, influential investors such as pension funds, and central bankers and policy makers all across the world.

Bridgewater’s first mandate to manage money came when their client World Bank entrusted them in 1987 with a 5 million dollar investment to be managed in fixed income. This trend from merely advising on asset management to actually handling the client’s account was followed by two more of their clients, Kodak and Loews, who wanted them to manage their currency exposure in 1990.

The first three clients set a trend that they follow till today — they accept and manage institutional money only, unlike many hedge funds that rely on asset growth from high networth families. Most notably, they guide a lot of pension (both public and corporate) fund money, not only in the sense of being one of the many managers chosen by them, but offering strategic and tactical advise at the highest level of asset allocation. Out of the 270 clients they have today, although many are US-based (mostly public pensions funds and corporate pension plans), a quarter of assets come from foreign government sovereign wealth funds. Needless to mention, the category of their clients vindicates their management abilities.

So far they had created a semblance of hedge fund offerings for their clients on an ad hoc basis. But in 1991, seeing asset management as a natural extension of their advisory services, they officially offered their fund Pure Alpha as a platform to all their clients and prospects.

While alpha is simply a measure of an investment’s excess return over its benchmark, the Pure Alpha fund seeks to outperform the collective returns of the markets it engages in while taking on lower risk. Portable alpha and alpha overlay, as made famous by Ray Dalio, are the central principles of the Pure Alpha fund which seeks to disengage alpha from beta.

In theory, portable alpha has a zero beta or market risk. This is achieved by hedging the portfolio holdings by using derivatives (futures options, or swaps). For instance, if a manager holds the S&P 500 index, he can hedge his position by selling futures on the S&P 500 index, thereby eliminating any beta. Of course, there is a cost associated with the derivative trade and that would eat into the returns. The idea behind the Pure Alpha fund is to reduce beta and then create alpha through active management. Without the active management, this would be a zero-sum game.

Adding the alpha overlay strategy, the fund invests in a diversity of asset classes ranging from foreign bonds to inflation-indexed bonds to currencies to commodities to global equity markets. So it diversifies the sources of alpha itself. Also, the fund fortifies against risk by optimizing the mix of assets classes in such a manner that there is a low level of correlation among them. To execute this dual complex strategy involves constantly analyzing fifteen or more asset classes and simultaneously placing forty or more trades in each asset class.

Since its founding, the Pure Alpha Fund has only lost money in three years (never more than 2%) and averaged a 15% compounded gain net of fees. The fund remained relatively stable through the downturn of the early 2000s (implosion of internet bubble and 9/11) and in the financial crisis of 2008 returned 14% gross. In 2009, however, the fund returned 3%, trailing the equity markets.

In 1996, Bridgewater introduced its second investment vehicle: the All Weather fund. As the name implies the fund is engineered to produce high risk adjusted returns regardless of the current market conditions. This fund was initially started as a personal trust fund for Ray Dalio as he wanted a vehicle that did not rely on alpha generation by active management (since he could not choose the managers for his family after his death). So while the Pure Alpha fund seeks to separate and optimize alpha, the All Weather fund does the same for beta.

The central tenet of the All Weather fund is risk parity. While the concept of risk parity has been around for a while, Bridgewater was the first to offer a product based on it. Today risk parity has become somewhat of a buzzword in institutional investing circles and many similar offerings are cropping up with differences in what they mean by risk parity.

Ray Dalio’s initial approach to risk parity was simply to look at the problem of a traditionally balanced asset allocation fund – say, 60% equities and 40% bonds. While on the surface this traditional allocation seems balanced, the reality is that it highly imbalanced from a risk perspective – 90% of the risk comes from equities and only 10% from the bonds. Hence, these traditional portfolios are far from being truly balanced and in reality rely heavily on equities to achieve their targeted return, thereby highly subject to the volatility (beta) of equities (which defeats the purpose of being balanced to begin with).

The solution, according to Dalio, is easy: leverage the bond (or any other low beta component of the portfolio) allocation enough so that the associated risk or beta for each asset class matches the asset allocation of the portfolio. By levering the low beta asset and (if needed) de-levering the high beta asset, a portfolio can achieve a 60% equity beta and 40% bond beta. Back testing this formula gives a 3% plus return advantage over the traditional portfolio while reducing volatility. The reason most balanced fund managers do not follow this simple strategy is because they confuse leverage with risk.

Akin to the Pure Alpha fund, the All Weather fund further diversifies itself beyond simple equity and bonds by investing in commodities, global debt, currencies and derivatives. Unlike the Pure Alpha fund, which charges the traditional 2-20 to its clients, the Al Weather fund has very low charges as the strategy depends on matching the returns of the markets it invests in.

Since its inception, the All Weather fund has returned 9.5% (net of fees) which is 50% above most institutional balanced portfolios. Further, it has done so by assuming 25% less risk by deploying the risk parity strategy. It is worth noting that while the fund has indeed abided by its risk parity strategy, it has deviated from Ray Dalio’s original idea that the allocation would remain the same. Under more active stewardship of co-CIO Robert Prince, the fund went into a safe mode with no allocation to equities after the collapse of Lehman Brothers.

In mid-2011, Bridgewater launched a new fund titled Pure Alpha Major Markets that is spearheaded by the co-CEO Jensen. Since the original Pure Alpha fund is closed to new investors, this fund was mainly created to accommodate new commitments of over 7 billion dollars. The fund also seeks to have more liquidity by investing in major markets only.

Investment Philosophy:

As already described, Bridgewater applied innovative quantitative strategies to manage money under its two global macro flagship funds. Besides separation of alpha and beta, resulting in alpha portability/overlay and risk parity through systematic diversification in all asset classes, the firm continuously pioneered or enhanced many other strategies: global bond overlay program, advising US Treasury on creation of inflation-indexed bonds, super-long duration bonds for liability management, currency overlay program, and others.

Most recently, Ray Dalio contextualized the subprime-led financial crisis as the “D-process” – deleveraging and deflation – and distinguished it from a traditional recession, thereby recommending investors strategize differently than they would in a regular downturn.

All the innovation and constant tweaking of strategies by their army of analysts are first and foremost guided by Ray Dalio’s meta-philosophy as described in his book “Principles” (available for free on their website). The book has three parts and a fourth one that has yet to be written. Part 1 lays down the significance of espousing principles in general (regardless of whether they are in agreement with his or not). Part 2 expands on his fundamental principles that guide everything he undertakes in his life. Part 3 shows how he applies these principles at Bridgewater. The yet unwritten Part 4 is going to be about his investment principles.

While it would be convenient to have the investment principles laid out, in reality the general principles described in the book truly lay out what guides his investment strategies. These basic (yet hard to practice) principles are: (1) Setting one’s own goals, (2) Using independent thinking to generate ideas on how to achieve the goals, (3) Stress-testing the ideas against the smartest brains to find out where they are wrong, (4) Cautiously guarding against letting any over-confidence creep in through the ideas and reminding oneself of the virtue of “not knowing”, and (5) Awareness and acknowledgment of reality as the ideas are executed, experiencing the results of the decision and constantly reflecting upon the process and how to better it.

Now, translating this into investment parlance: (1) Establishing desired returns, (2) Creating a strategy to achieve the returns with the lowest risk possible, (3) Back-testing and detailed analysis and challenging of the strategy, (4) Deploying the strategy with diversification, spreading the bets because one does “not know” what will actually happen in the future, and (5) Readiness to acknowledge the strategy is not working because of the current realities of markets and tweaking it accordingly.

The third part of the book extrapolates hundreds of decision-making rules from this five step process that are applied by all employees regardless of their rank in the firm. The decision making tools have actually been incorporated in the firm’s proprietary software so that there are numerous check points before a strategy or tactic is executed. Also, true to the fourth principle of challenging one’s investment thesis against the best of the best, at Bridgewater all employees are encouraged to challenge anyone’s ideas without regards to their seniority. In essence the book has become the cornerstone of how to continuously generate improvement and innovation in money management at Bridgewater.

Manager Biography:

Ray Dalio bought his first stock when he was twelve years old. It was the early 1960s and since he worked as a caddy he overheard all the golfers talking about the boom in the stock market. He bought shares of Northeast Airlines. What was his investment strategy? It was the only stock that he knew of that was trading below 5 dollars and therefore he reasoned he could buy many shares figuring that was a “good thing”. The company was on the verge of bankruptcy but was acquired by another airline and the shares tripled in value. His (over)confidence in his investment abilities was soon shattered by reality when he lost money in his following trades. In his book Principles he attributes the five step process to this experience.

In late sixties he attended Long Island University. While there he became interested in trading commodity futures as they had very low margin requirements. After graduating in 1971, he spent the summer as a clerk on the NYSE. This was of course the summer of Nixon Shock and he experienced firsthand the breakdown of the global monetary system of Bretton Woods.
He went on to acquire an MBA from Harvard Business School in 1973 and in the same year became Director of Commodities at Dominick & Dominick LLC. After spending a year there, he traded futures at the brokerage firm of Shearson Hayden Stone, where his role comprised assisting businesses hedge their market risk by using futures. One year later he founded Bridgewater Associates.

Today he appears on the Forbes 400 List with an estimated networth of 3.5 billion dollars. In July 2011 Ray Dalio officially gave up his role as a CEO and adopted the title Mentor. He continues to be a co-CIO along with Prince and Jensen as co-CIOs.

QUOTES

“Constantly worry about what you are missing.”

“The truth came out in 2008: many hedge funds were packaging up beta and selling it at alpha prices.”

“Since I believe that a big common mistake that caused many investors problems in 2008 was not having a broad enough perspective, I believe that one of the most important lessons or those who did badly in 2008 is to have a timeless and universal investment perspective, which means to broaden your perspective to understand what happened in long ago times (e.g., in the 1930s) and faraway places (like Japan and Latin America). Ask yourself ‘what would it be like if we had another year, or another two years, like last year’ because an examination of history shows that this is well within the realm of possibilities. Nobody really knows what will happen, but we all need to consider the full range of possibilities, make sure that our strategies make the worst case scenarios tolerable (i.e., really control risk!) and look for ways to maximize our opportunities. Taking a timeless and universal perspective helps us to do that.”

“Risky things are not in themselves risky if you understand them and control them. If you do it randomly and you are sloppy about it, it can be very risky.”

“I’m always trying to figure out my probability of knowing. Given that I’m never sure, I don’t want to have any concentrated bets.”

“Alpha is zero sum. In order to earn more than the market return, you have to take money from somebody else.”

“Many people still confuse leverage with risk, but the reality is that levering up low-risk assets so you can diversify away from risky investments is risk reducing.”

“The effectiveness of democracies is always tested during periods of economic stress.”