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April 2004


How Dalios Bridgewater wooed the pension funds

The quantitative shop now has more institutional money than anyone else
writes Iain Jenkins

ay Dalio doesnt talk like a hedge fund manager. He is far too theoretical for that, peppering his description of his business with references to alpha, beta and benchmarks. Yet he has

Maybe it isnt that surprising that Dalio doesnt sound like a hedge fund manager, because his company has its origins firmly in the traditional investment world and is managing close to $63 billion of institutional assets. The real surprise is that he doesnt sound like a traditional investment manager either. Instead, he uses a hybrid language somewhere between the two worlds. And that is his edge

built Bridgewater into one of the biggest and fastest growing hedge fund groups in the world with over $8 billion of assets and there is no sign of the growth coming to an end any time soon.


APRIL 2004



and the edge of his Westport-based firm. Over 14 years ago, when Dalio started to tell his institutional clients that there was a smarter way to manage their money and that was called alpha overlay, very few of them understood the message. Today, that has changed and Bridgewater is now the biggest manager of hedge fund money for institutions and it may well have found a way for hedge funds to crack the elusive institutional market. It is no accident that Bridgewater is helping a number of the largest institutions reshape their hedge fund investments as the firm is just the type of organization that the big institutions like. It is transparent. It has a clearly replicable quantitative-driven process that invests across bond, equity, commodities and emerging markets using liquid instruments. And above all, it is preaching a message that the institutions, which have been battered by equity market volatility and hurt by low bond returns, now want to hear. Sadly, however, Dalio doesnt believe that institutions will embrace hedge funds overnight and abandon the long-only world that is dominated by the beta chasers. Nor should they, he says, because hedge funds alone are not the best solution. They should be used in conjunction with the beta that can be found in the market and the institutions should harness the power of both worlds through alpha overlay. The way this generally works in practice is that an institution uses a derivative, which captures the return from their chosen benchmark. This might be the S&P 500 for the equity portion of their portfolio. It now has its beta. It then uses Bridgewater to find the alpha, which has the effect of turbo-charging market returns. Some institutions, such as Pennsylvania State Employees Retirement System, are using funds of funds. Others are turning to Bridgewater, for the alpha. Given that Dalio is now running the tenth largest hedge fund group in the U.S., his views on the value of beta in a portfolio are pretty heretical. Such is his personal belief in beta, that he has put all of his family trust into traditional products and not into hedge funds, because he says the search for alpha is a zero sum affair. Someone has to lose and someone has to win, but working out who will win and who will lose with any certainty is a challenge that requires special skill. The result of this zero sum alpha game is that, as the hedge fund industry grows, average returns will fall. As this happens, there will be a widening in the dispersion of returns between the genuinely smart managers and the rest. This will make the job of finding the smart alpha generators all the more difficult. As an example, Dalio points to merger arbitrage, saying that the average merger arbitrage fund is now the same as the return you would have got by mechanically buying all the target companies and shorting all the acquiring companies on the announcement of a merger. The average manager is, therefore, adding no value. They are simply providing market return that a monkey could get by implementing the

strategy, which means they are, by Dalios definition, only generating beta returns. Furthermore, over the long term, beta is the best way to outperform cash. So, how does Dalio square this heretical view with his belief in hedge fund strategies and the search for alpha? Dalio realized that running a hedge fund was a smarter way of managing funds than running long-only money. Underpinning his view is the assumption that traditional managers are generating 90% of their returns from beta and 10% from alpha, while hedge funds are shrinking the beta and magnifying the alpha with the help of leverage. To do this, hedge fund managers still have to be smarter than average managers, but assuming they are, they then have the tools to generate non-correlated returns. Bridgewater then worked out that you could split the beta from the alpha and offer institutions a way to benefit from the beta, which he believes is still desirable over the long term, while simultaneously generating alpha. Over the past 14 years, the Bridgewater hedge fund strategy has produced an annual return of 19.7% gross of fees with its worst year occurring in 1999 when it was down only 1.5%. Little wonder that the institutional money has started to flow, now accounting for almost $8.1 billion of the firms assets, with a dozen institutions adopting the alpha overlay approach over the past 18 months. Bridgewater is also finding fans in the fund of funds community for its off-the-shelf hedge fund called Pure Alpha. Half of the $1.1 billion of assets in the fund come from funds of funds, which arent interested in the firms theories about separating alpha from beta. What appeals to them is the fact that the firm has a process which seems to be replicable through numerous cycles. This is because the model is driven by two main factors value and momentum with both inputs being constantly revised. Bridgewater also seems to be immune to the hedge fund disease of constant, disruptive departures of key staff. Quantitative operations are not nearly as exposed to the departure of key personnel as fundamental shops. In addition, all key staff hold equity, options or phantom equity in Bridgewater, which helps explain why the firm has such exceptionally low staff turnover. And Bridgewater is still growing. Dalio believes that the firm could double assets from here to close to $16 billion without impacting returns because the strategy invests in very liquid markets and doesnt involve moving in and out of the market. The fear for other hedge funds is that the Bridgewater formula will be difficult to copy. They know they lack the institutional contacts, necessary transparency and stable talent pool. Moreover, few have the capacity that the big institutions will need. And Dalio himself raised the ironic possibility that hedge funds may not benefit from big institutions inevitable move into the market. While they may get some of the institutional assets by adjusting their approach and learning the language of the institutional world, they may end up facing increasingly stiff competition from the traditional investment institutions, which will start moving in increasing numbers into the alpha world.

Given that Dalio is now running the tenth largest hedge fund in the U.S., his views on the value of beta are pretty heretical