Thursday, January 24, 2013

World's Biggest Hedge Fund in Deep Trouble?

Stephen Gandel of Fortune reports, Why the world's biggest hedge fund missed big in 2012:
Here's what needs to be asked about giant hedge fund Bridgewater Associates and its founder Ray Dalio: Is this guy really worth $2 billion a year? That's roughly the amount investors paid his firm in management fees in 2012.

That question got a lot tougher in the past 12 months for pension fund managers around the country, who for the past decade and a half have been funneling cash to Dalio and his firm, which now manages $142 billion - making it the largest hedge fund in the U.S.

That's because Dalio had a lousy 2012. By some reports, he was down for most of the year. Blog ZeroHedge appears to have a copy of Bridgewater's most recent client letter, which details how it did in 2012. Dalio's flagship hedge fund, Pure Alpha, ended the year up just 0.8%. That was much worse than the market in 2012. Stocks, as measured by the S&P 500, were up 13%. Bonds were up just over 4%. Even the average mutual fund manager, who gets paid far less than Dalio, was up 0.9% in the fourth quarter alone, just slightly better than Bridgewater did all year. For the full year, stock mutual fund managers were up 14%, handily beating Dalio.

Of course, every investor has off years. And Dalio is certainly entitled to one. Even with last year's flub, he still has one of the best track records of any investor. Pure Alpha has been up an average of 14% a year since 1991. Fortune, back in 2009, was one of the first major publications to profile Dalio and his success. So you could almost shrug off the $2 billion for an off year, I guess. (In good years, Dalio's company gets much, much more. In 2011, when his flagship fund was up 20%, his firm took in around $6 billion in fees.)

But a close look at Dalio suggests 2012 could be more than an anomaly.

Dalio generally believes most people get diversification wrong. They hold 60% of their portfolio in stocks and the rest in bonds, or some similar split, and call it a day. Dalio says stocks have historically been far riskier than bonds, so if you truly want to diversify your portfolio you have to put far more money in bonds than stocks.

According to the Wall Street Journal, Dalio preaches what he calls risk parity to institutional investors around the country, and has gotten a number of large pension funds to lever up their portfolios and buy more bonds. And they're doing this at a time when everyone appears to be growing more and more worried that the bond market could be in a bubble.

That sounds scary, but that's not the real problem. Dalio is, after all, about diversification. And he has recently joined the chorus of people who are warning that the bond market is overvalued.

If bonds do drop, Dalio's bets on stocks in theory should balance that out. The real problem is bonds are no longer the safe bet they once were. Rick Rieder, who is chief investment office of fundamental fixed income portfolios at Blackrock (BLK), says 30-year bonds were actually more volatile than stocks last year.

So Dalio's real bet -- that bonds are less risky than stocks -- is what was really off in 2012, and with interest rates at all-time lows that looks likely to continue for some time.

This is a simplistic analysis. Dalio only really practices risk parity with a little less than half of the money he manages. It's called the All Weather fund, which actually did better than Pure Alpha in 2012. Pure Alpha, on the other hand, as you can see from the numbers from ZeroHedge makes dozens of bets on all types of investments. But here too you can see the shift. Among the biggest movers in its portfolio recently are investments in US and European bonds. Its stock market investments, by comparison, have been less volatile.

Most people believe Dalio's success was built on his great macro calls, a swashbuckler able to stay one step ahead of the global economy. But while Pure Alpha is not the fully diversified All Weather, its outsized returns have been driven by the same general Dalio investment thesis: That investors have traditionally taken on too much stock market risk, and need to spread their bets.

That's been the true key to Dalio's success. And during a time of falling interest rates, it has worked great. And it may continue to. But it's also just the type of talk - that something like levering up your portfolio is safe as long as you use that leverage to buy bonds - that always pops up, and gets taken as gospel, just as bubbles are about to burst.
So is Bridgewater in deep trouble? Let me begin by reassuring lots of nervous pension fund managers who have invested billions with Bridgewater that there is nothing fundamentally wrong. The article above raises some good points but it's also misleading and inaccurate.

First, on performance, Paul Shea of Value Walk states the following: "The return across the funds was around 4%, trailing the S&P 500 but the fund was stronger compared to other funds in 2012. The firm’s All Weather Strategy, however returned 16% for the year, beating the S&P 500, and most hedge funds." That's hardly a disaster.

One thing is true, Pure Alpha has been up an average of 14% a year since 1991 and continued delivering stellar results despite a mushrooming of assets under management to well over $100 billion. Having seen the rise and fall of many hedge fund titans, that's extremely impressive.

But last year was a tough year for macro funds and some of the industry's elite managers were simply not bringing home the bacon. Why was this the case? Because Ray Dalio, Louis Bacon and others simply couldn't deliver stellar results in an environment where global central banks clipped their wings, engaging in massive quantitative easing. That environment bodes well for structured credit funds, which isn't the expertise of these macro funds.

Second, risk parity isn't just about levering up the bond portfolio. In an excellent article, Samuel Lee of Morningstar explains the risk-parity approach to portfolio construction which Bridgewater pioneered and is now being offered by mutual funds and why it still makes sense:
Several risk-parity mutual funds in the United States attempt to earn higher returns by applying leverage to balance the volatility contributions of a variety of asset classes, including commodities, corporate bonds and currencies.
The theory and expectation is that leverage allows the funds to be more efficiently diversified without sacrificing returns; an unleveraged portfolio will have high risk-adjusted returns but low absolute returns -- the problem faced by the Permanent Portfolio. Why should this theory hold?

In an ideal world, it should not. Even in a less-than-ideal world, investors would observe the strategy's excess return and arbitrage it away. Is the risk-parity cat out of the bag? Maybe not. If your reaction upon hearing the word "leverage" is alarm, you are not alone. And this widespread revulsion may keep risk-parity profitable. Leverage is anathema to many investors, meaning a sizable class of investors resort to riskier assets to achieve their expected-return targets.
We are observing such a shift today: investors are shifting from bonds to dividend stocks to boost their yields, even though classical finance theory says that they should be borrowing money instead. The result of leverage aversion is that low-volatility asset classes offer higher risk-adjusted returns, which can be exploited by investors willing to use leverage -- that is, risk-parity investors.

Even if you don't fully trust these newfangled risk-parity strategies, it's still worthwhile to stress-test your portfolio to see how sensitive it is to all four economic scenarios.
Lots of smart investors, including the Oracle of Ontario, use leverage across all asset classes to "juice up" their returns. In good years, this helps them handily beat their policy (benchmark) portfolio. In bad years, like 2008, they risk crashing and burning again (but they learned a lot from that experience and manage liquidity risk much tighter).

So is everything peachy at Bridgewater? Are there legitimate reasons to be concerned about performance going forward? As I've already stated when I saw Texas Teachers losing its Bridgewater mind, there are plenty of things that raised yellow flags in my mind about where Bridgewater is heading and how big it can grow while maintaining its focus on performance.

When I invested in Bridgewater over 13 years ago, it was just starting to garner serious institutional attention. Now, the whole world knows about Ray Dalio, Bob Prince and Bridgewater's approach. When I hear investors telling me investing in Bridgewater is a "no-brainer," I get very nervous and start thinking that the firm's success has become its worst enemy.

Let me be clear, I've met Ray Dalio, Bob Prince and many others from Bridgewater. There is no doubt they run a first-rate shop, striking the right balance, and deserve their place among the world's biggest and best hedge funds. But in this industry success is a double-edged sword and I don't like seeing hedge fund managers plastered all over news articles and engaging in silly deals.

Also, as I explained yesterday, there are good reasons to chop hedge fund fees in half, especially for these large quantitative CTAs and global macro funds. Why should Ray Dalio or anyone else managing over $100 billion get $2 billion in management fees? It's ridiculous and I think institutional investors should get together at their next ILPA meeting and have a serious discussion on fees for large hedge funds and private equity shops.

In my opinion, these large funds should charge no management fee (or negligible one of 25 basis points) and focus exclusively on performance. The "2 & 20" fee structure is fine for small, niche funds that have capacity constraints or funds just starting off and ramping up, but it's indefensible for funds managing billions as it transforms them into large, lazy asset gatherers, destroying alignment of interests with investors.

Now, one can argue that Bridgewater is becoming the next Pimco, a mega asset manager which successfully manages a lot more in assets. That's fine but then why charge 2 & 20?

One other thing concerns me. If the great rotation out of bonds into stocks is just getting underway, what does that mean for Bridgewater which sees dangerous dynamics as economies slow? Will they continue to underperform in an environment where central banks keep pumping liquidity into the global system to manage tail risks?

I don't know, lots of things to maul over. I'm still not convinced that bonds are dead but I also believe this bull market gets no respect and most money managers are ill-prepared for a post fiscal cliff melt-up in US equities.

Those of you who want to read more on the world's biggest and most successful "beta" hedge fund, should read this comment posted on Zero Hedge yesterday. Ray Dalio and Bob Prince explain the All Weather story. Some of the comments posted are also worth reading while others are frivolous nonsense (this is why I don't allow comments on my blog).

Below, embedded an interesting interview where Ray Dalio discusses the importance of meditation in his life. Lastly, New York magazine discusses how Dalio has conquered yet another asset class: terrifying giant squids that live 2,000 feet beneath the sea. Watch some images from the Discovery channel discussed in this ABC News report. Jacques Cousteau would have been proud.