Nov 3, 2012

Bridgewater, Dalio and The Gospel of Diversification – Post-Modern Value Investing?


Hurricane Sandy is bearing down on New York City and the only silver lining is an early market close has given me the leisure to open up The Alpha Masters by Manet Ahuja. I’ve only just finished the first chapter covering Ray Dalio but already there are things worth sharing.

For those who don’t know, Ray Dalio is the radically transparent founder and co-CIO of  Bridgewater Associates LP, one of the worlds largest and most successful hedge funds. He is also one of the most interesting characters in the hedge fund world.

I first encountered him watching an interview on Charlie Rose (here). I recall being impressed if not inspired by the clarity of his thinking, and the methodical ruthlessness with which he approached problems. His requirement that any discussion of a complex subject be contingent on the participants commitment to having a thoughtful conversation, uncontaminated by emotion was a breath of fresh air. Since then I’ve read a few portraits of Ray Dalio the man, and his infamous principles (which I recommend) but it wasn’t until reading this chapter did I get a chance to really try and puzzle out his investment process.

Stripping Things Down

The first nugget of wisdom that made me pull out my highlighter was as usual, something that confused me.  When discussing the lessons Bridgwater took away from the 1994 bond rout Ray Dalio states the following.

“We learned that if you had the same positions in a variety of countries, that you could take our relative views in each country and trade those on a duration-neutral spread basis. By doing so they would systematically guarantee the fact that we wouldn’t have correlations to the broader market. So what we did was we discovered essentially how to restructure the balancing of our positions to produce greater diversification. That carried forward into all the markets we traded.”

After giving it some thought, what I think this boils down to is an excellent example of how  the firm has refined their approach the markets. Apparently before the bond rout of 1994, Bridgewater had assumed that their holdings of foreign government securities were independent of anything happening in the U.S. bond market. But in ’94 the markets taught them this was not the case and they subsequently refined their positions so as to exclude the interest rate risk component from what they believed was a pure play on credit.

The leap outlined in the former passage lies at the heart of the process Bridgewater uses, but its importance is only really fully grasped when it is given context by the latticework of theory. Something I only began to discern after wrestling with the following passages:

The Gospel Of Diversification

‘To create the proper balance and diversification is even more important than any particular bets. Which is the opposite of how most investors operate.’

“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 successfully, you will make a fortune. You’ll get the pot of gold at the end of the rainbow.'”

“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.”

This sort of blew my mind. Here is the worlds biggest hedge fund manager and he doesn’t mention value or mispricing once. Instead he recounts the basic portfolio theory every business student learns in undergrad. And yet the more I pondered it, the more I came to believe that this is the driver behind Birdgewater’s success.


Somewhat obscured in the preceding passages are four words that I believe are the key to understanding what make Dalio’s approach so successful. The first of which is good:

Dalio says if you have 15 or more good, uncorrelated bets, you will improve your return to risk ratio by a factor of five.

The bets, the investments, have to be good. Or more mathematically, the bets have to, in aggregate have a positive expected value.  This stands if not opposed to then at least in stark contrast to the rigorous standards of value investing where you want each bet to be near flawless. This however, is not to say I think the firm is lax in their investment standards but rather that they may accept an investment that say Seth Klarman would not. Nor does this deviation make them a priori inferior, in fact we need only look to the precedent set by Buffet, who has made colossal wagers on companies that his mentor and master Graham would never have undertook himself.


Dalio says if you have 15 or more good, uncorrelated bets, you will improve your return to risk ratio by a factor of five.

In my opinion this is where we really start getting into what makes Bridgewater unique. Unique because I really believe that when he says uncorrelated he means uncorrelated and he will search the world to find them. Currencies, commodities, fixed income, equities and whatever else you can think of, Bridgewater wants uncorrelated revenue streams flowing into it’s proverbial pot of gold.

In trying to understand why this is so important for Bridgewater, consider the following.  The investor who finds ten great bets in the U.S. equity market may be a great investor but if he is a hedge funding manager offering monthly liquidity and using leverage, he may not be a professional investor for long if the U.S. equity market goes into a prolonged slump. The double criterion that bets be uncorrelated as well as good is precisely why they can accept bets that are merely good.

Their Drivers

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.

This, for me, was probably the most interesting sentence in the chapter, and in my view, where Dalio hints at what you might call Bridgewater’s secret sauce. Eschewing the traditional quantitative measure of correlation, it would seem the firm tries to take a more fundamental approach to understanding how assets are related.  Though fundamental should not be confused with old-fashioned, it appears a highly systematic and mathematically sophisticated process.

“To generate alpha, Bridgewater follows a fundamental and systemic investment process. It uses analysis of past events to help stress-test its thinking of how markets work, using over 100 million data series that extend across developed and emerging countries, and in some cases back 100 years or more. Once the criteria are proven to be sound, they can be processed instantly to stay on top of market developments.”

Thus, the type of analysis Bridgewater brings to bear when evaluating correlation is probably several orders of magnitude more sophisticated than any effort most individual investors can muster. Further, an institution of their size will naturally have a breadth of product expertise outmatching even the most veteran individual investors (not to mention choice pricing). And for many that is ok; if you don’t need liquidity or use leverage your return to risk ratio won’t be as important to you. In fact, many hardcore value investors have been known to court volatility as it gives them the opportunity to increase their stakes at even more attractive levels. (Although I’m not sure how much they love it once they are fully invested )

For more experienced quantitative practitioners, this kind of thinking may be old-hat, but as someone who has largely looked askance at anything related to portfolio theory with its efficient market heritage, reenforcing the idea that uncorrelated bets can do so much to enhance your risk/reward ratio is at least thought provoking.

Building The Disparate Future

Bridgewater is a company that takes large institutions’ money and manages it for them. In doing so it is obliged to provide reasonable liquidity while also avoiding painful drawdowns if it is to uphold its reputation as a world class hedge fund. The best way it has found to do this is to maximize the risk / reward ratio offered to clients.  What I find most interesting and at the same time not surprising is that in doing so Dalio appears to be more focused on the risk than the reward.

Having said that, I cannot help but think that this Gospel of Diversification, with its focus on understanding correlation and thereby achieving volatility minimization is not in some way a very post-modern incarnation of value investing ideals. For what is volatility minimization if it is not a focus on principal protection, in the face of the threat of drawdowns and leverage?

Writing this I am reminded of the following quote by Michael Lewis talking about Michael Burry’s philosophy of investing:

“Burry did not think investing could be reduced to a formula or learned from any one role model. The more he studied Buffett, the less he thought Buffett could be copied; indeed, the lesson of Buffett was: To succeed in a spectacular fashion you had to be spectacularly unusual. ‘If you are going to be a great investor, you have to fit the style to who you are,’ Burry said. ‘At one point I recognized that Warren Buffett, though he had every advantage in learning from Ben Graham, did not copy Ben Graham, but rather set out on his own path, and ran money his way, by his rules… I also immediately internalized the idea that no such school could teach someone how to be a great investor. If it were true, it’d be the most popular school in the world, with an impossibly high tuition. So it must not be true.'”

That quote is probably worth a post in itself and is courtesy of the Street Capitalist blog post: Learning From Michael Burry, one of my all time favorites.

So What Do You Think?

Am I taking this too far? Is this fundamental driver correlation analysis merely hocus-pocus? A clever rouge used to cover up a massively leveraged carry trade, or something else?

Your criticisms, and comments are welcomed!

Sep 9, 2012

No Mean Sum Book Review – The Dhandho Investor


Dhandho! I recently stumbled upon a video of Monish Pabrai and Guy Spier speaking to students at UC Davis, and so enjoyed both the content and clarity of thought that, although I promised myself I wouldn’t read any more value investing books until I finished Security Analysis, one Sunday morning I picked up The Dhandho […]