Ray Dalio is the founder of Bridgewater Partners (BWP), the largest hedge fund in the world. He has recently published a book Principles in which he describes the work and life principles that have contributed to Bridgewater’s success. The primary goal since the firm’s inception in 1975 was to be an “idea meritocracy” based on the principles of radical open-mindedness, radical transparency and a “believability weighted” decision process. At Bridgewater, employees must openly debate the strengths and weakness of their colleagues (including peers, reports and superiors) as well as the likelihood of various economic scenarios and the merits of alternative investment strategies. Ray believes that it is only through a rigorous testing of ideas that winning investment themes will emerge. The forty-year historical record seems to bear out his thesis. BWP currently manages $160 billion of client assets. According to industry sources, the firm has produced more client wealth than any other hedge fund.
Ray attributes this success to rigorously defining and following a set of principles. On the other hand, maybe Ray and his team have just been extremely lucky. Either way it is an interesting story.
According to the book, BWP has developed and relies on two primary investing strategies. They are known as “Pure Alpha” and “All Weather.” Pure alpha is based on Ray’s collection of trading rules in commodity, currency, interest rate and equity markets. Each rule is based on a documented and tested cause effect logical relationship. Over the past forty years, Ray claims to have created upwards of 1,000 such rules. At some point in the company’s development, a researcher came up with what Ray calls the Holy Grail chart. This chart shows the decline in portfolio volatility due to the addition of strategies with various degrees of correlation with the base portfolio. If the correlation is substantial (like, say 0.6) then the benefits of diversification are exhausted after adding just a few additional rules. However, if the correlation between the base portfolio and the trading rule is low (like, say 0.0) then the potential reduction in portfolio volatility is much greater as many more rules are added. The idea of pure alpha is to implement a substantial number of uncorrelated trading strategies. The overall strategy can be implemented using liquid instruments (futures contracts, for example) and is available as an add-on or “overlay” to a client’s existing portfolio. Currently, BWP has $80 billion of pure alpha positions.
The other major BWP strategy is the All Weather portfolio. This is an allocation across major asset classes in such a way that the portfolio will perform reasonably well in any of what Ray calls the four possible economic scenarios – inflation greater or less than expected and economic growth greater or less than expected. The major asset classes are equities, risky bonds, default free bonds, inflation-adjusted bonds and real assets (commodities and real estate). In its most basic implementation, the All Weather asset allocation is based on equal probabilities of the four possible economic scenarios.
The All Weather portfolio is consistent with recent developments in financial theory. Back in the 1970s it was widely believed by academic economists that the primary source of systematic risk and a positive risk premium was the market portfolio, as measured by a broad equity index fund. Research since the 1970s has revealed multiple sources of risk premiums including the value and size equity factors, term and credit bond factors, momentum and the liquidity factor (where illiquidity is a source of return). The All Weather portfolio is attempting to diversify across sources of systematic risk premiums. It is a passively managed portfolio, with no attempt to “beat” the market. The excess return (that is, the return over the risk free return) on the All Weather portfolio may be referred to as “beta” or market return, as opposed to “alpha” which is the return to skill. Importantly, beta return is available to every investor, while alpha return is a zero sum game.
Ray is a big believer in the value of artificial intelligence. He distinguishes between data mining and machine learning on the one hand, and expert systems on the other. The former approach relies on the computer identifying relationship between variables based on searching historical data bases. The latter approach, the one Ray prefers, is based on human agents identifying rules based on cause effect relationships between variables and then “training” the computer to implement the rules. In Ray’s view, the expert system model is more robust because the identified relationships are more likely to persist in the future.
Both the All Weather and Pure Alpha portfolios were developed by Ray and his partners through a rigorous procedure of debate and statistical testing. As his company became larger, Ray realized he needed to develop management processes to handle the growth. Over the past few decades he has done so and in his book reveals principles for managing in the workplace and in your personal life. He hopes that even after he has retired or expired the company will continue to apply the principles and by doing so continue to generate extraordinary results.
Work and Life Principles
Ray’s principles are pretty interesting. First and foremost, be radically open and truthful about your strengths and weakness and those of your colleagues. Aggressively seek to identify and address problems anywhere in the operation (particularly in your areas of responsibility). Apply a five step process to improving a process: set lofty goals, identify problems, diagnose root cause of each problem, develop a plan to fix the problem, and implement the plan. Realize that people are wired differently, with different skills. Very few people (Ray may be a rare exception to this) have the requisite skills to handle all five steps of the improvement process. Recognize your weaknesses and pull in additional resources as needed. Develop, monitor and track metrics on everything you can think of, including merits of your peers. For example, keep track of how often each person’s stated views and forecasts are sound and accurate. Collect these results into a scorecard of some sort. Ray uses what he calls a “Baseball Card” for each employee that details strengths and deficiencies and is available for everyone in the company to see. These scorecards are then used to measure the “believability” (credibility) of each employee on each issue. Major decisions are reached by consensus, but where each person’s vote is weighed by their believability.
Combating Goodhart’s Law
These principles suggest a thoughtful and intense approach to decision making. They certainly appear to be working. Aside from the obvious financial success of the firm, the idea of the All Weather portfolio is a valuable contribution to financial theory and the practice of investment management. It is more difficult to assess the contribution to creating market beating results (alpha). The ability to continue doing this over time runs into Goodhart’s Law that says that any empirical relationship will stop working once it is widely relied upon. It will be interesting to check back in a decade or two and see if Ray’s principles have enabled the company to outperform in his absence.