You know there is a bear market prowling because Ray Dalio has been gathering a lot of attention lately. Dalio, one of the richest and most successful investors on the planet, is worth listening to at any time but especially when markets are running scared. That’s chiefly because his firm, Bridgewater Associates, which runs $140bn (£115bn) or so, is best known for putting the ‘hedge’ into hedge funds.
Over a career now closing in on 50 years, Dalio has built net worth – depending on the source – of $15bn to $20bn. The actual amount is irrelevant; the figure is simply to indicate that his grasp of the investment game is as good as it gets. Much of that grasp comes from doing more, and deeper, research into what powers the world’s economies than anyone else. Paul Volcker, a former head of the Federal Reserve, the US central bank, suggested that Bridgewater had a bigger research department, producing better research, than the Fed. No surprise, therefore, that when the Fed wanted to launch index-linked bonds it turned to Bridgewater for advice.
So Dalio and Bridgewater combined can do fearsome complexity. Happily, they can also distil their message into accessible simplicity and offer solutions for coping with bear markets that are within the reach of DIY investors. Their simplified, but not simplistic, view of investing is that the return on any security is driven by whether both economic growth and inflation are rising or falling relative to expectations. Sure enough, however sophisticated the analysis, on matters relating to the performance of securities, somewhere the pace of growth and of inflation will be major factors.
Dalio suggests that most investors – institutional and private investors alike – are vulnerable because their portfolios are too exposed to equities. That’s fine for coping with inflation, but poor when it comes to living with economic contraction, which – almost always – will come from unforeseen factors. Holding fixed-interest bonds can sort out that difficulty, but only to an extent. Clearly, if lack of growth combines with excessive inflation – much as 2022 is demonstrating – then fixed-interest securities will suffer too.
Something more is needed that can cope with both faltering growth and rising inflation. That something is often commodities. For example – as shown in the 1970s, 1980s and today – oil can be a partial hedge against slowing economic growth (admittedly, in part because price fixing of oil or supply constraints apply the economic brakes in the first place). Gold can also do a job, especially as a counterweight to rising inflation.
Better still are inflation-linked bonds because they are almost guaranteed to do well when inflation surprises on the upside. So ‘linkers’ become the fourth major component of what Bridgewater labels its All Weather Fund. This was launched in 1996 chiefly as a vehicle to manage the Dalio family’s wealth without the need to hire expensive fund managers whose performance would be uncertain anyway.
Granted, in the real world the All Weather Fund uses leverage to generate its returns, a tactic often beyond the means of private investors because of the cost of borrowing. Costs aside, Dalio has argued that investors should be less fearful of borrowing. That’s because, with the appropriate level of gearing, returns on all assets can be made more or less identical. For instance, it is intuitively easy to grasp that if fixed-cost debt is partly used to fund a holding in government bonds then their returns will become more like those of equities. Yet the process of equalising returns in this way makes for less volatile portfolio performance than holding a conventional ungeared portfolio of bonds and equities.
Several papers on the Bridgewater Associates website (www.bridgewater.com) explain the background to the fund and how it is constructed. The make-up of assets is shown in Table 1. Essentially, the fund is four mini portfolios rolled into one. Each has an equal weighting, made up of assets as shown in each quadrant of the table. So, for example, to benefit from expectations of rising economic growth (see top left-hand quadrant) a portfolio would hold equal amounts of equities, commodities and both corporate and emerging market debt.
It is worth stressing that the overall composition of the fund does not change. It stays the same to be ready to cope with whatever eventuality comes along. That said, clearly – although perhaps largely theoretically – as investors feel more bullish or bearish they can lever returns up or down using debt.
Nor is there a right or wrong time to buy it. As an explanatory note by Bridgewater from 2012 says, the fund “grew out of Bridgewater’s effort to make sense of the world, to hold the portfolio today that will do reasonably well 20 years from now even if no one can predict what form of growth or inflation will prevail”. Simultaneously, it guards against investors’ overconfidence which often “pushes them to tinker with things they do not deeply understand...With the All Weather approach, Bridgewater accepts that they don’t know what the future holds and thus choose to invest in balance for the long run”.
If the approach shown in Table 1 seems a bit complicated, there is a simpler version of Bridgewater’s All Weather approach run by the Lazy Portfolio ETF website. The Ray Dalio All Weather Portfolio – so named, presumably, to distinguish it from the Bridgewater original – uses just five US-orientated exchange traded funds (ETFs) with weights as shown in Table 2. With back-testing going to 1973, Lazy Portfolio claims an average 5.0 per cent a year return adjusted for inflation with a standard deviation of not quite 8 per cent (in other words, two years out of three, returns were within the range of plus 13 per cent and minus 3 per cent). In the past 10 years, returns have averaged an inflation-adjusted 3 per cent with a standard deviation of 6.4 per cent.
|Table 2: Lazy Portfolio's All Weather Fund|
|Long-dated govt bonds||40%|
|Medium-dated govt bonds||15%|
|Source: Lazy Portfolio ETF|
To put together a UK-equivalent portfolio exclusively using ETFs would be straightforward. There is no shortage of the necessary funds available on the London market. However, it seems sensible to add index-linked gilts into the mix since iShares £ Index-Linked Gilts (INXG) is ready and waiting. Sure, splitting the government bond holdings evenly between fixed interest and linkers would have done the portfolio’s returns no favours over the past two years. That, of course, is not the point. What matters is to have the protection that index linking offers over the course of an investing lifetime and through all weathers.
Talking of inflation, which we have been, the great economist of the Chicago school, Milton Friedman, famously noted that inflation is “always and everywhere a monetary phenomenon”. Of course we can debate that, as many have. Talk of inflation and the subject of money will never be far away. Yet as to the extent to which playing around with money’s cost and supply will affect the inflation rate: everyone knows it will, but no one knows when and to what extent the effect will be felt.
The great inflation of the 1920s, that which did its level best to undermine Germany’s Weimar republic, is a good example. Legend has it that Germany’s government and central bank colluded to destroy the value of the mark to nullify the cost of rebuilding France’s shattered post-1918 economy, which, to the average German, seemed more like retribution than reparations. True, that was a factor. Equally important, however, was the pent-up spending power accrued by Germans during the 1914-18 war. This was invested in government debt, which had risen 20-fold during the war, and in bank deposits, which had risen five times. When those liquid assets were turned into consumption they stimulated their own inflationary feedback loop.
In other words, rising inflation was induced by inflation itself. Which makes one wonder whether a mini Weimar republic has been created here in the UK by Covid-19’s perverse effects. The chart indicates the correlation between the UK’s money supply and its inflation rate where money supply is measured as the multiple of the UK’s output (GDP). So a rising multiple shows that more money is needed to raise GDP by a given amount.
This multiplier topped out in 2010, after the 2008-09 financial crisis, and again in 2020 as the government threw money at the economy it had shut down. On both occasions inflation responded, although this time around much more vigorously. This, presumably, is where supply-side constraints and other factors from the real economy enter the picture. Who knows to what inflationary peak that will take the UK or when it will get there. All the more reason, one might think, for an all-weather approach to investing.