Friday, June 20, 2014

The Soul of a Hedge Fund Machine?

James Freeman of the Wall Street Journal recently wrote a long article on Bridgewater Associates, The Soul of a Hedge Fund 'Machine':
How do you build the world's largest hedge fund? Bridgewater Associates founder Ray Dalio says he did it by creating a culture of "radical truth and radical transparency." Mr. Dalio's perhaps radical belief is that "everything is a machine"—including organizations and even the individual people within them. At his firm's Westport, Conn., headquarters, we are discussing the human machines at Bridgewater and the equally fascinating machine known as the U.S. economy.

As for the people at his firm, the idea is to encourage everyone to accept unvarnished criticism as a treasured opportunity to learn and to solve problems. This is intended to allow constant refinement of business processes—also known as machines within the firm—from how Bridgewater buys office furniture to how it evaluates the world oil market.

But human machines don't always welcome complete candor. And at Bridgewater they have to get used to internal software that conducts a non-stop evaluation of their performance based on daily entries from colleagues and even rates their credibility on particular issues. This doesn't mean the software makes all decisions. When the system recently reported that the company's head receptionist was underperforming, executives decided that it was a case of the software not being calibrated to effectively measure her work.

If an employee is willing to accept this unique culture, the company promises a rigorous search for the truth with a minimum of politics and subjective decision-making. Mr. Dalio says that anybody in the company can get up in front of a crowd and say that something doesn't make sense. At other firms, he says, "most people keep that to themselves." But at Bridgewater "you have a right and an obligation to say I think this is terrible and explore whether or not that's true." He adds that there's no reason it should not happen at other organizations but that it doesn't happen "because of that emotional ego barrier."

For most new Bridgewater employees, "it's a little bit like entering the Navy SEALs," says Mr. Dalio. "There's a period—usually about 18 months—of sort of adaptation to this. And some make it and some don't make it. And so we call it 'getting to the other side.'" He adds that "the other side looks like: They can't work anywhere else and the reason they can't work anywhere else is they don't know what anybody's thinking anywhere else. They don't have an ability to speak their mind anywhere else. They don't have the guardrails of their weaknesses. Everybody's got weaknesses. They can't candidly address weaknesses.

"We describe it as: there's the upper-level you and the lower-level you. The human brain is part thoughtful man," he explains, "and part animal. And you have to drag yourself. And we see the struggle as between the upper-level them and the lower-level them." In other words the brain wants honest feedback but the emotions aren't always ready to handle it. "It's not a struggle between us and them typically. It's a struggle between what do they want" and "what happens in their emotional reactions to that."

He believes that the Bridgewater culture has been critical to the growth of the firm, because in financial markets "if you can't have independent thinking" and "you can't know what your weaknesses are, and sort those things out, you're not going to be successful."

How does he implement this culture? "I tape everything so everybody can listen to every conversation, except if there's a very personal matter" or "if we're going to execute a trade or something proprietary." Otherwise "everything is taped so everybody can see it and we go through a process of valuing critical feedback to try to together discover what the patterns are" and how improvements can be made.

Created in Mr. Dalio's New York City apartment in 1975, Bridgewater now manages $160 billion in assets. A "global macro" investor that focuses on understanding national economies, the firm has a history of reporting market-beating returns to clients—and even made money during the financial crisis—but posted disappointing results in 2012 and 2013. Bridgewater appears to trade less with some of Wall Street's giant banks than some large funds do, but Mr. Dalio says that it's not a policy of his firm to avoid Wall Street. "We just go wherever the transaction costs are cheapest."

Just as he sees individuals and business processes as machines, Mr. Dalio also sees an economy the same way. And that "means that there are cause-effect relationships" and this allows one to understand that "most things happen over and over and over again." Mr. Dalio says that, "In order to really understand the machine I believe that I have to have timeless and universal rules" across all time and all countries.

The emphasis on transparency within the company doesn't mean that Mr. Dalio is seeking media attention. "No, I hate it," he says. But he has consented to this interview, and has published papers and a video online at EconomicPrinciples.org, because he wants everyone, including Washington policy makers, to look at the economy in a new way—to understand the machine.

"Because I've watched repeatedly so many misunderstandings [that] have bad consequences. And I think that rather than trying to discuss what should be done that we have to start with the basics of saying: how do things work?" He adds, "If we can agree on how it works, then that's a foundation for what should be done and also what will prevent problems. So an example of that would be printing money. Is printing money inflationary? Well let's just go back to basics and look at that question."

While people debate whether the Federal Reserve's money creation will or will not cause inflation, Mr. Dalio says it's first necessary to get a clear view of the monetary machine. Stated simply, he says, all purchases in the economy must come from money or credit. He therefore sees a role for central banks in helping to prevent a steep downturn when the availability of credit plunges during a financial crisis. "The printing of money offsets the contraction in credit," he says, "and relieves the liquidity problem."

The Fed has been creating a lot of money since the crisis. Mr. Dalio says his team at Bridgewater has studied 67 historical periods of deleveraging, when countries or economies had to reduce debts after a credit boom. He pronounces the current U.S phenomenon "a beautiful deleveraging"—with the Fed adding money to the economy to maintain overall spending. And as people in the economy extend more credit, he says, the Fed should in turn reduce its money printing.

Still, he says, "I worry about the effectiveness of monetary policy in the next downturn." That's because the first tool the Fed can use to goose the economy is to lower interest rates. But since rates were already very low during the crisis, the Fed decided to employ a second tool: creating money as it purchased Treasury and mortgage bonds through a program known as quantitative easing. But such purchases are less effective than lowering rates, says Mr. Dalio, because while interest rates directly affect nearly everyone as they buy houses and cars and shop with credit cards, the people who own financial assets and who benefit from QE don't necessarily buy more things as a result. QE works best when not much money is in the system and asset prices are low. With lots of money now in the system and the prices of financial assets having soared since the depths of the crisis, such policies will likely be less effective.

"There will have to be a monetary policy number three," says Mr. Dalio. "This is an issue I haven't yet figured out." He adds that "every cyclical peak and trough in interest rates was lower than the one before it since 1980." One therefore wonders what firepower the Fed will have if it is again called upon to prop up the economy. "We'll probably find a way to manage through that," he says. But for now we are in "neither boom nor bust" and Mr. Dalio doesn't expect much volatility over the next few years.

A lot of readers will no doubt think that we need activity in other parts of the American economic machine, rather than just Fed money printing, to return to robust growth. Mr. Dalio makes it his business to study national economies around the world and of course he has a machine to evaluate them.

Surveying the rise and fall of economies over time, Mr. Dalio and his colleagues have developed a model intended to predict national economic growth rates over 10 years. The model is based 35% on the country's level of indebtedness and 65% on competitiveness and "by that I mean what you get for what you pay," he says. The single "most important factor is what it costs to have an educated person."

For this reason, Mr. Dalio can see significant unrealized potential in Russia because of its very low level of indebtedness, which means "they have the power to buy," and due to its highly educated and cheap labor force. But culture matters, too. Another key to growth "is the notion of self-sufficiency," he says. "Economies in which a greater percentage of the population feels the rewards and penalties of their actions tends to grow faster than those that don't."

In Russia, he notes, "there's no inventiveness, there's no entrepreneurship, there's no small business development." International indexes note high corruption and limited property rights. Mr. Dalio sums up the results for economic growth when few people have ownership opportunities: "Nobody ever washes a rental car."

Such factors are why he still sees a bright future for the U.S., even with lots of debt and moderately expensive educated workers. The U.S. has "a very high rate of innovation," and technology development "in my opinion is going to produce and is in the early stages of producing productivity miracles." He compares America's "connectivity revolution" to Gutenberg's invention of the printing press, and he also notes that the U.S. is becoming energy self-sufficient. "Plus we have rule of law, we have property rights."

One area where the U.S. "could make a lot of progress" is in improving public education. "That's a high-potential area," he adds. It's unclear whether anyone can understand the machine known as the U.S. public-school system, but it's safe to say that it doesn't operate much like Bridgewater.

As for the U.S. economy as a whole—as well as all the people within this great machine—Mr. Dalio offers a simple rule to help avoid the next credit crisis: Don't allow debts to grow faster than income.
It's nice to see Ray coming out again to speak to reporters. Why did he agree to this interview? It's all about Bridgewater's 'marketing machine', and the fact that the world's largest hedge fund is finally performing well after two lackluster years.

According to Bloomberg, Bridgewater’s Pure Alpha II rose 2.1 percent in May and 6.1 percent in 2014, and the fund now manages an astounding $160 billion and Westport Now states the fund now employs 1600 people. It's a far cry from when I invested in Bridgewater over 11 years ago when they had a little over $10 billion in assets and around 120 employees.

I'm not sure how this explosive growth has impacted the firm's culture, but in my experience, the bigger organizations get, the worse the culture becomes. The senior managers become all paranoid, lots of nonsense infighting and internal turf wars where people look out for their interests rather than that of the organization.

But let me give Bridgewater the benefit of the doubt, after all, they are performing well so far this year when most of their peers are getting stung by calm markets:
Some of the biggest investors on Wall Street are losing money with wrong-way bets in markets around the globe, a surprising black eye amid a rise in stock and bond prices.

Hedge-fund managers including Paul Tudor Jones, Louis Bacon and Alan Howard are among those who have misread broad economic and financial trends. Some have lost money as Japanese stocks fell, while others have been upended by the surprising resilience of U.S. bonds.

An unusual period of calm has exacerbated problems for many trading strategies dependent on volatile markets. The losses by these so-called macro investors are contributing to a trading slowdown hurting the largest investment banks.

The flagship fund at $15 billion Moore Capital Management LP, led by star investor Mr. Bacon, was down 5% this year through the end of May, the firm has told clients. Mr. Jones's flagship fund at $13 billion Tudor Investment Corp. is down 4.4% this year, according to a person familiar with the firm.

By comparison, the S&P 500 index is up 5.4% this year, including price gains and dividends, and the Barclays U.S. Aggregate bond index, a standard measure for debt investments, is up 3.4%.

Funds operated by Mr. Howard's Brevan Howard Asset Management LLP, Fortress Investment Group, Caxton Associates LP, Discovery Capital Management LLC and Balestra Capital Ltd. also have posted losses, according to people familiar with their performance.

It is always difficult predicting broad trends, and the losses could quickly reverse. But hedge funds charge high fees with the expectation of impressive performance in any kind of market, and these investors built reputations with prescient market picks. Those running so-called macro funds generally bet on macroeconomic trends in global markets while investing in stocks, bonds, commodities and currencies.

"Macro investors have had a very, very hard time with the fact that bonds have done well and volatility is so limited," said Matt Litwin, director of research at Greycourt & Co., a Pittsburgh-based investment firm that invests $9 billion in hedge funds and other firms but has been reducing some of its investments with macro hedge funds. "There are a lot of losers."

Many funds piled into Japanese shares last year when they began rallying. But the Nikkei Stock Average is down 7.1% since reaching a high in January, amid doubts about the sustainability of Japan's economic recovery. Fortress, a $63 billion firm, has acknowledged to investors in its Fortress Macro fund that it was hurt by both this year's run-up in U.S. Treasury prices and weakness in the Nikkei. The Fortress Macro fund was down more than 3% this year as of June 6.

Brevan Howard Capital Management's roughly $28 billion flagship fund was down 3.8% through June 6, according to an investor in that fund, with interest-rate and bullish Nikkei bets among its losers. Caxton Associates in New York, an $8 billion firm, has lost money every full month this year and was down more than 6% at the end of May, according to the firm's investor updates, partly due to bearish currency positions.

Kyle Bass's $2 billion Hayman Capital Management LP has lost money on wagers against some European countries, as well as a bet on further weakening of the Japanese yen, people familiar with the firm say. The Dallas-based firm's main fund suffered its steepest two-month drop in five years at the start of the year and fell more than 6% in the first quarter, these people say.

Woodbine Capital Advisors LP, a well-known fund run by Joshua Berkowitz, a former senior trader at Soros Fund Management, recently announced plans to stop managing outside money after disappointing returns.

Larger funds have a handicap in slow markets: They can be too big to trade in smaller markets that are seeing more volatility.

"You can't put $1 billion in coffee contracts and expect to get out quickly, so the big funds can't have these smaller plays in their portfolios," said Sam Diedrich of Pacific Alternative Asset Management Co., an Irvine, Calif., firm that invests in hedge funds.

The setbacks for macro investing—a style made famous by George Soros and others who anticipated past market turns—come after a rush of investors embraced this approach to trading, thanks to its impressive performance during the financial crisis.

Macro funds on average gained 4.8% in 2008, even as the S&P 500 fell 37%. Other investors saw how John Paulson, a onetime merger specialist, made $20 billion in profits at his firm, Paulson & Co., anticipating the 2008 meltdown, and they vowed to adopt macro strategies as well.

Today, there are 1,865 hedge funds focusing on macro investing, up from 1,233 in 2008, according to HFR Inc., which tracks the hedge-fund world. That growth is much faster than that of the overall hedge-fund business. Macro funds manage $508 billion, up from $279 billion in late 2008. But macro funds have had three years of disappointing returns.

The poor results are prompting investors to pull money from macro funds and are forcing some funds and other financial groups to scale back their trading. Large banks including Goldman Sachs Group Inc., GS -0.08% J.P. Morgan Chase& Co., Morgan Stanley and Barclays PLC execute many hedge funds' trades. Such banks tend to benefit from rising trading volumes and volatile markets.

Amid the recent quiet, many banks have posted soft results, and some have laid off traders. Goldman Sachs President Gary Cohn said last month that unusually slow markets had made it "difficult" for Wall Street firms. Morgan Stanley said this month it would cut jobs from its currency and rates-trading businesses in response to tepid investor activity.

Some worry that a lack of volatility will continue to haunt various markets, perhaps until the Federal Reserve signals higher interest rates are imminent following a long period with benchmark rates near zero.

"I actually find myself daydreaming about winning 'Dancing With the Stars' on some days in the office," Mr. Jones, of Tudor, joked at an investment conference this spring. "It's gotten to be very difficult, when you depend on price movement to make a living, and there is none."

Average daily bond trading has fallen to about $734 billion, the lowest level in more than a decade, according to the Securities Industry and Financial Markets Association. The CBOE Volatility Index, the most widely cited measure of investor expectations for daily stock-market swings, on June 6 slipped to 10.73, its lowest closing level since 2007, according to FactSet.

"These are very uninteresting times in the market," Jared Dillian, a former trader who now writes a newsletter, recently told his subscribers. "The goal is to not fall asleep."
Lack of volatility and calm markets will continue to haunt these large macro funds. Some are betting on the decline of the euro but the fact is not much has changed since I wrote my comment two years ago on why macro funds aren't bringing home the bacon.

Importantly, central banks have effectively clipped the wings of these large macro funds. Ray Dalio can question the effectiveness of quantitative easing but the reality is the Fed is doing whatever it takes to prop up equity markets in a desperate attempt to stoke inflation expectations, even if QE exacerbates wealth inequality. It will likely fail but in the meantime, enjoy the liquidity party and melt-up in risky stocks.

And the irony is Bridgewater made most of its money this year by going long bonds. I remember my exchange with Ray in front of Gordon Fyfe in 2004 when I was pressing him on why I thought deflation is the end game and he blurted out: "Son, what's your track record?"

Well Ray, since you admire "radical truth and radical transparency," let me be brutally honest with you and all your other superstar hedge fund peers. I honestly think you're a bunch of insanely overpaid gurus who rely more on the marketing machine, collecting that 2% (or 1.5%) management fee in good and bad years. Even 1% on $160 billion translates to $1.6 billion for turning on the lights!

I would love for Bridgewater and other hedge funds to publish their IRRs net of fees and all other costs. In fact, the SEC should demand this from all asset managers. Then we can gauge real alignment of interests.

When I read that for most new Bridgewater employees, "it's a bit like entering the Navy SEALs," I roll my eyes and feel like hurling. Oh yes, once they "get to the other side" they have mastered the machine. Who believes in this self-promoting , self-serving crap?!?

I'm sorry to disappoint you folks but Ray Dalio doesn't walk on water and neither does any other hedge fund or private equity superstar. Many of these gurus were at the right place at the right time and while they performed well, they are also the prime beneficiaries of the big alternatives gamble undertaken by dumb public pension funds desperate for yield as they try to avert a looming catastrophe.

I've challenged the Bridgewaters and Blackstones of this world to do away with management fees altogether (or reduce them to 50 basis points) and rely entirely on their performance fee, which is high enough. So far, nobody has accepted this challenge and why should they? So many dumb pension funds taking advice from useless investment consultants shoving all their clients in the same brand name funds, it's an alternatives orgy out there.

Enjoy it while it lasts because it ain't going to last for long. There will be a radical transformation in the alternatives business in the decade ahead and many pension funds praying for an alternatives miracle will be sorely disappointed. They are all underestimating liquidity risk in private and public markets.

I challenge Ray Dalio and other hedge fund gurus to a few things:
  • Publish your IRRs, net of all fees and costs, for each fund going back monthly to inception.
  • Publish your turnover rate every year with an explanation if it rises.
  • Publish your research and letters for everyone, not only your clients (What ever happened to Bridgewater's research piece "Selling Beta as Alpha'?)
  • Last but not least, diversify your workplace and hire persons with disabilities. Don't worry, it will do wonders in counterbalancing the pervasive arrogance at your shops.
I wish you  all a great weekend. Please remember to to donate or subscribe to my blog. If you take the time to read my comments, it's because there is value there so please take the time to show your appreciation by contributing or better yet subscribing via PayPal on the top right-hand side. Also, feel free to add your comments as I recently enabled comments on my blog.

Below,  Agecroft Partners Founder and Managing Partner Donald Steinbrugge and Bloomberg Contributing Editor Fabio Savoldelli discuss hedge fund performance. They speak on “Market Makers”and state investors are happy with hedge funds. This is an excellent discussion, take the time to listen to it.