Who is the world's best investor? Quite likely the popular vote would rank Warren Buffett as number one, followed by George Soros. But the popular vote would really only decide the world's best-known investor and that's quite different from the best.
How about Ray Dalio as the best? Ray who? With a name like that it sounds as if he might have connections with The Mob (or is that Ray Liotta?), whereas arguably Ray Dalio has discovered something that's as lucrative as organised crime yet legal. He has discovered 'pure alpha' and, in the process, his flagship hedge fund has accumulated more profit for its partners - almost $36bn (£23bn) at the last count - than any other hedge fund to date. It has also bagged a pretty tidy fortune for Mr Dalio - around $10bn - and has earned him the reputation of controlling a cult rather than running a fund management company.
Don't believe
To start, let's get this thing about the cult out of the way. Mr Dalio-s company - Bridgewater Associates, based in a leafy part of Connecticut - is hardly the first to be labelled as such. Think of Google today; or McDonald's, Walt Disney or IBM at their peak. They have all been labelled 'cult-like'.
What sets Mr Dalio's Bridgewater apart is its 'search for truth'. That's a big thing - perhaps the big thing - according to Mr Dalio. "You have to understand how reality works," he says, in a tone much like John McEnroe, another - and better known - native of the New York suburb of Queens. "So it's often more valuable to know what you don't know and I so know that I can be wrong. And we should all recognise that about ourselves." If that sounds a bit convoluted, it's how Mr Dalio puts a point across - rambling his way through; hands doing lots of pronating and supinating.
Rambling maybe; but reputation has it that Bridgewater's search for truth leads to a brutal regime where aspiring fund managers who can't hack it intellectually - or possibly just say the things that Ray does not agree with - are hounded out. Hence the 'cult' allegations.
"When I think of a cult, it means 'believe this'," says Mr Dalio. "For us, it's the very opposite. The number one principle is 'don't believe'. Think for yourself and let's go through a process to find out what's true. It's a belief system, if you like, but it's the opposite of a cult."
More relevant to Bridgewater's success - and serving the aim of successful investment - this search for truth means that the fund manager has built a research department that has a bigger staff and produces better analysis than the US central bank, the Federal Reserve, according to Paul Volcker, a former chairman of the Fed. As a result - and not altogether flippantly - Mr Dalio is reckoned to know more about financial crises than anyone else on the planet, and that includes Ben Bernanke, the current chairman of the Fed.
Maybe that was why Bridgewater was able to position itself both for the credit crunch that followed the collapse of Lehman Brothers in 2008 and the crisis within the eurozone. As a result, Bridgewater Pure Alpha, the flagship fund, made gains of 45 per cent in 2010 and 24 per cent in 2011, bringing its value to perhaps $80bn.
The Pure Alpha fund does what its name says - it seeks the returns that only come from being smarter than other investors. In other words, alpha is a zero-sum game. As one fund manager wins with a trade, another loses because each one is on the opposite side of the same trade. Multiply that notion across all the trades in the world's financial markets and the net result is zero. In fact, for investors in funds, the net effect is slightly negative because they have to cough up the exorbitant fees that hedge fund managers charge to search for alpha.
Bridgewater does its searching by trawling through more data than anyone else to find the negative correlations in asset returns that no one else has spotted. Having unearthed these, it constructs portfolios of pairs of them and back-tests the portfolios for as many years as data will allow. The result is portfolios that have a good chance of delivering specified returns.
Such a return does not even have to be very high. The crucial factor is that it must have a good chance of being delivered - in the jargon of portfolio theory, the 'standard deviation' of returns must be low. If that's the case, then borrowing can be used to lever up returns. Say in a given year a fund manager knows his portfolio has a 0.7 probability of making a 6 per cent return and he can borrow funds at 3 per cent; if so, then it's sensible to borrow and lever up returns to, say, 10 per cent, or whatever level his clients feel comfortable with.
It's straightforward in theory. In practice, it's forbiddingly difficult, which is why so many hedge fund managers have been found out by the credit crunch and its aftermath.
Forbiddingly difficult though it is, Mr Dalio's craft does offer insights even for private investors, especially in the principles that underlie Bridgewater's All Weather Fund, a lesser-known fund that he set up in 1996 to husband much of his family's wealth. Mr Dalio explains: "Because picking alpha requires talent in those who select managers and I could not be sure of this after my death, I wanted the portfolio to be 100 per cent based on beta and geared to produce an equity-like return. I call it 'all weather' because it's designed to perform well across different economic environments."
All Weather's underlying principles start with conventional portfolio theory, which acknowledges that risk rises with returns; in other words, the higher the returns that an investor targets, the more he must accept they will be volatile. The next step absorbs the lesson of a hugely influential paper by a Nobel Prize-winning economist, James Tobin, that defined the so-called 'separation theorem'.
This says that an investor, having separated his attitude towards risk from his portfolio selection, would realise that stock selection was pointless. Because all he then need do to target an expected return is to buy 'the market' and dilute or enhance the market's returns by holding cash or borrowing it to get to the return he was seeking. If the market offered an 8 per cent return, cash returned 4 per cent and the notional investor was happy with 6 per cent, then he could keep half his wealth in the market and the other half in cash. But if he targeted 10 per cent, then he would have to put 1.5 times his wealth into the market by borrowing at 4 per cent.
| RAY DALIO – FACT FILE |
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1949: born Jackson Heights, Queens, New York 1961: buys his first stock - Northeast Airlines - because it was the only stock he had heard of that was trading for under $5 a share 1973: graduates from Harvard Business School with an MBA 1974: sets up Bridgewater Associates from a bedroom in his East 64th Street, Manhattan apartment, producing a daily market newsletter 1985: Bridgewater starts to manage money with a $5m mandate from the Word Bank to invest in bonds 1991: sets up Bridgewater Pure Alpha fund 1996: sets up Bridgewater All Weather portfolio 2006: Bridgewater ceases managing conventional bond and currency portfolios 2012: LCH Investments, a hedge-fund adviser, names Bridgewater Pure Alpha the world’s most profitable hedge fund, having generated $36bn profit for its partners in its 21-year history. Forbes magazine estimates Mr Dalio's wealth at $10bn, making him America's 44th richest person |
Essentially, Mr Dalio takes this notion and applies it to a portfolio with a broad range of asset classes. The effect is that returns on low-risk assets such as bonds can be levered up to produce equity-style returns. It also means that, with the appropriate level of gearing, returns on all asset classes can be made identical. However - and this is the vital point - the process of equalising returns in this way makes for a less volatile outcome than with a conventional ungeared portfolio of bonds and equities. Conversely, for the same level of volatility as a conventional portfolio, the All Weather approach would generate higher returns.
Mr Dalio says: "If investors can get used to looking at leverage in a less prejudicial black-and-white way - 'no leverage is good and any leverage is bad' - they will understand that a moderately leveraged, highly-diversified portfolio is considerably less risky than an unleveraged non-diversified one."
And the proof seems to be in the performance. From July 2007, when the world's credit markets started to tighten, to April 2010, equity markets worldwide fell about 21 per cent; a conventional portfolio of 60:40 equities and bonds fell 6 per cent yet the All Weather portfolio gained almost 19 per cent.
But if even this is too sophisticated for some private investors - and it does assume that somehow or other they can gear up their portfolios with especially cheap money - Mr Dalio offers two further insights. The first is that it is better to have a portfolio mix of equities and bonds than almost all equities, which is the error that so many investors make. The point is that over a lifetime of investment all major asset classes are most likely to have a long phase of underperformance (think bonds in the 1970s and 1980s; equities in the 2000s). So why risk being wholly exposed to a sustained bear market in just one of these classes when the risk-adjusted long-term return of bonds and equities combined is pretty much the same as the return on equities alone?
Second, investors really only need to focus on two variables: whether economic growth is rising or falling, and whether inflation is rising or falling. These two - and their direction - will power bonds, equities and commodities. So get the mix and the timing right and long-term investment performance is likely to be good.
But which of these assets should investors be majoring on now? "Figure it out for yourself," is what Mr Dalio would say. And if you get it wrong to start with, that's good. As he also says: "You learn so much more from bad experiences than the good ones. Make sure you take time to reflect on them. Remember that pain plus reflection equals progress."
The A-Z of alpha and beta
In portfolio theory - unlike the Greek alphabet - first there was beta, then came alpha. In fact, both terms derive from a core piece of statistics, a regression analysis. This is where the relationship between two variables - say, a stock market's returns and the performance of a fund manager's portfolio - is used to make predictions.
Beta shows the connection between the predictor variable (the stock market) and the response variable (the portfolio). A value of more than 1.0 for beta means that the response variable (the portfolio) would be a geared play on the predictor variable's returns. So a portfolio with a beta of 1.5 could be expected to rise 1.5 per cent in a month where the market rose 1.0 per cent.
Alpha is the figure that quantifies by how much the response variable (the portfolio) could be expected to change before the effect of the predictor variable comes into play. In the above example, it might be 0.4 per cent; though it could easily be negative. But the key point is that alpha's value is unaffected by the predictor variable.
Transpose this to the investment world and alpha - really just a statistical by-product - becomes vital because theoretically it shows how much value a fund manager adds. Simultaneously, beta quantifies the low value-added stuff, the return that a fund manager - whether he's bright or dim - gets simply by assuming the so-called systematic risk of the market in which his fund is invested.
So from precise beginnings, in the investment industry these two have dumbed down to generic terms that convey the passive investment decisions that a fund manager makes (beta) and the active decisions (alpha). Beta is easy to capture because it’s a ride on a market, whereas alpha is inaccessible. The only way to generate alpha is, on average, to outsmart other investors.
