The world's biggest hedge fund (pg 2)
Dalio, a sturdy six-footer who favors open-collar cotton shirts and corduroys when he's not meeting with clients, works out of an unostentatious office brimming with photos of his wife and four children and has a view of the Saugatuck River, which flows through the property. The rustic feel of his surroundings pleases him. A member of the board of the National Fish and Wildlife Foundation, he's an avid fisherman and bow hunter who has gone after everything from Cape buffaloes to wild boars. He says that his attraction to outdoor activities - he also enjoys snowboarding - is primarily a manifestation of his appreciation for the beauty and sophistication of nature. By comparison, he says, "anything that man sees or does is overly simplistic."
To maintain his mental energy and creativity, Dalio meditates about five times a week for 20 minutes, a practice he says he adopted when "the Beatles started doing it in 1968." He is also a rabid music fan with omnivorous tastes. He keeps a box at the opera in New York City, makes an annual trek to New Orleans for Jazzfest, regularly goes salsa dancing with his wife, and has a passion for the blues.
Like many billionaire money managers, Dalio has his own charitable foundation. For the past three years, he's funded newspaper and radio ads supporting a campaign called "Let's Redefine Christmas," which challenged people to give donations to charities as gifts instead of indulging in the holiday ritual of conspicuous consumption.
Although Dalio says he is not a particularly big reader, these days his desk is piled high with some 20-odd books on economic debacles, such as "Essays on the Great Depression" by Ben Bernanke and "The Great Crash of 1929" by John Kenneth Galbraith. Inside each are Post-it notes and hand-scribbled thoughts in the margins. He also keeps close at hand a binder he's put together with detailed, 100-page timelines of the four major deleveraging episodes of the past century - the hyperinflation of the Weimar Republic in the 1920s, the worldwide crash during the Great Depression in the 1930s, the Latin American debt crisis of the 1980s, and Japan's lost decade of the 1990s. He says the timelines provide "a virtual experience of what it would be like to trade through each scenario."
Out of those four historical examples, Dalio says that our current situation most closely resembles the Great Depression because of the global breadth of the problems. But he doesn't like to use the term "depression." He thinks it's too scary, evoking as it does images of hobos and Hoovervilles, and distracts people from focusing on the mechanics of what is going on. He prefers to use a term he coined: "D-process."
Most people, says Dalio, think that a depression is simply a really, really bad recession. But in reality, the two are distinct, naturally occurring events. A recession is a contraction in real GDP brought on by a central bank tightening monetary policy, usually to control inflation, and ends when the central bank eases. But a D-process occurs when an economy has an unsustainably high debt burden and monetary policy ceases to be effective, usually because interest rates are close to zero, and the central bank has no way to stimulate the economy. To compensate, the value of debt must be written down (risking deflation) or the central bank must print money (a trigger of inflation), or some combination of both.
In recent years the level of debt as a percentage of GDP in the U.S. has skyrocketed past previous highs last seen in the early 1930s. And the Federal Reserve's benchmark rate is now hovering just above zero. To Dalio, therefore, it's clear that a D-process is under way. "It seems very likely that stocks will get materially cheaper," he says. "We have to go through an important debt restructuring process, and a lot of assets are going to be for sale, huge numbers of assets. And there's going to be a shortage of buyers."
Even investors in most hedge funds won't be immune. According to research by Bridgewater, the hedge fund industry in aggregate is 75% correlated to the S&P 500, an issue on which Dalio has been sounding an alarm for a couple of years now. "Too many people have a systematic bias toward positive economic growth," he says. "I think that what we're going to probably have is an economy that's going to get worse, with most people positioned for it to be better." By the end of the D-process, he expects that the reverse may well be the case.
Dalio grew up in suburban Long Island, N.Y., the only child of a jazz musician and a homemaker. Unlike his father, who played clarinet, piccolo, flute, and sax, Dalio never had the patience to learn an instrument. As a boy in the early 1960s, he caddied at a nearby golf course. The stock market was booming at the time and, at age 12, Dalio heard enough hot tips that he decided he wanted to get in on the action, so he went to see his father's broker. When his first purchase, Northeast Airlines, took off, he was hooked.
After attending Long Island University, he got an MBA at Harvard, spent a year as the director of commodities trading at brokerage Dominick & Dominick, and ended up working under Sandy Weill at CBWL Hayden Stone, where his job was to help businesses hedge their market risks using futures. After a year he struck out on his own as a consultant, helping companies hedge interest rate and currency risk. On the side, he invested his own money and began to accumulate trading "decision rules" - at first jotted down on notebooks, later stored on computers - that could be back-tested to see whether they worked in different eras and markets. In the mid-1980s, he parlayed his reputation for quality research into a chance to manage $5 million of fixed-income money for the World Bank, and produced spectacular returns. He launched his hedge fund portfolio in 1990 with money from Loews Corp. and Kodak.
It's no accident that Bridgewater's flagship fund is called Pure Alpha. The name reflects Dalio's commitment to an approach to investing - "portable alpha," or the separation of so-called alpha and beta - that was innovative when he started but is commonplace today in the wonkier corridors of Wall Street. "Ray Dalio recognized that the traditional model of portfolio construction was too constrained," says Angelo Calvello, a former executive at State Street Global Advisers and Man Investments and the author of a number of publications on portable alpha. "He really changed the way that people thought about investing and allocating risk."
In investing terms, beta is the passive return that a portfolio might get from the ups and downs of a benchmark such as the S&P 500 stock index. Alpha is the measure of a manager's return, with the same risk, in excess of the beta. For his own fund, Dalio devised an "alpha overlay" approach that allowed him to allocate a certain amount of capital to replicate an investor's chosen benchmark and then roam free among other asset classes looking for the best possible "alpha streams," or return opportunities. It was the perfect way to employ the trading formulas he had been accumulating over the years.
Then, Dalio says without irony, he discovered the holy grail of investing, "by which I mean that if you find this thing you will be rich and successful in investing." This grail is not, unfortunately, a talisman that a regular person might stumble on, but a formula: 15 or more uncorrelated return streams, either betas or alphas. According to Dalio, such a portfolio reduces risk by 80%.
The tricky part, of course, is finding a large number of reliable, uncorrelated, moneymaking sources of alpha in the first place. (If it were easy, everyone would do it). And it requires venturing far beyond the bounds of equities. Today, Bridgewater's computers scan the world for opportunities in roughly 100 different categories, ranging from directional bets on the price of industrial metals to relative bets on pairs of emerging market countries' interest rates. Having the fund so widely diversified reduces the risk of a major blowup - and it limits the impact that Pure Alpha can have on any one market.