De-leveraging, beautiful and beastly
Bridgewater's Pure Alpha is famed as the world's largest hedge fund, earning $13.8bn for investors in 2011 alone. But today, over coffee in a luxury London hotel, the focus for Bob Prince, co-chief investment officer of the Connecticut-based firm, is on a beta strategy called ‘risk parity'.
Risk parity steers asset allocation from money weighting to risk weighting. To counter the greater volatility of equities without reducing return, it leverages fixed-income exposures. Throw in commodities and other inflation-hedging assets and the resultant portfolio is intended to deliver a better risk-adjusted return.
Prince emphasises that Bridgewater's All-Weather strategy is the original risk parity exponent, with a track record back to 1996. He also likes to point out that roughly one in three of all Bridgewater's institutional clients are running money on this basis.
Moreover, of all the risk-parity specialists interviewed for the special supplement with this month's IPE, Bridgewater is the only one claiming that pension funds are running their entire asset allocation on a risk-parity basis. "For most [of our clients] it is a partial programme, but a few big US plans, ranging from $2bn to $100bn in assets under management, have switched over their entire allocation to this approach," he says.
As another distinguishing feature, Prince claims his firm is the only one in risk parity practising fundamental diversification - the balancing of exposures to the fundamental economic drivers of asset returns without relying on asset correlation assumptions (rival AQR, to take an example, would claim that it focuses on risk measures, but that the resultant allocations are similar).
Prince does not begin with a sales pitch, however. He wants to explain the economics of investing, and while a few facts and anecdotes are woven in, this discourse essentially turns into a courteous lesson on the Bridgewater philosophy. Questions are answered as they relate to that philosophy but, otherwise, little diversion is permitted.
As befits a lesson, in the beginning is understanding. Bridgewater believes in two fundamental drivers of asset returns - discounted economic growth and inflation. Because an asset is just the present value of its cash flows, and these cash flows are heavily affected by economic growth and inflation, asset pricing reflects the market's discounting of scenarios with respect to economic growth and inflation. Shifts in these discounted scenarios drive asset returns.
"Understanding how asset returns relate to the economic environment allows us to create a portfolio that is reliably balanced to unexpected shifts in the economic environment," says Prince. "This neutralises volatility without reducing return."
This does not mean to say that the firm is above the noise of the market. How the rest of the market discounts value makes for active investing. But the Bridgewater approach to asset allocation eschews predicting correlations when deciding allocations. Likewise, although Prince talks about returns, the All Weather philosophy emphasises measuring the risks posed by the forces of economic growth and inflation on returns rather than the other way around.
He is also at pains to stress that, being a passive strategy, it does not change over time. Turnover for the All Weather strategy is low. Bridgewater is as keen as any consultant or client to unmask alleged alpha as beta. Prince has analysed thousands of hedge funds and claims that the typical hedge fund index is 94% correlated with beta. The reason beta is such a popular play is that it gets investors exposure to economies, after all. But, for the same reason, Prince reckons the Sharpe ratio can hardly ever be much more the 0.25 from beta. For a firm best known for ‘pure alpha', a passive fund might seem pedestrian. Prince jokes that, initially, it didn't believe that it could actually charge external clients for the All Weather.
While the All Weather strategy does not alter its exposure to the various underlying betas, for those who want to further raise returns there is Pure Alpha (the two are kept clearly separate). The difficulty is getting Prince to expand further on Bridgewater's mechanisms for alpha. He does at least offer some insights on the issue of deleveraging, a current preoccupation of several Western governments.
It is fair to say that markets are in a funk when confronted with the economic equivalent of carrot and stick: quantitative easing at the same time as austerity measures. Stuck in the doldrums, the asset management industry becomes so desperate for a new story that everyone starts talking about risk. Bridgewater is already comfortable here. It divides deleveragings into two phases - the ‘ugly' and the ‘beautiful'. They can occur in repeated waves but it is the former which best describes Europe currently. As a recent Bridgewater paper co-authored by Prince, ‘Asset Class Returns in Deleveragings', explains: "There are problems servicing debt. The associated fall-off in debt growth causes an economic contraction, creating a self-reinforcing downward spiral in which the debt/income ratios rise at the same time as economic activity and financial asset prices fall."
Those falling asset prices worry Bridgewater less than most, however, because equities fall more than bonds and, with leverage, the All Weather strategy can maintain a reliable balance with bonds and other assets to offset those losses. Aggregating data from ‘ugly' deleveragings from different countries and periods (including US post-Great Depression, Japan post-real estate bubble, and Spain post-credit crisis), Prince reckons equities lose about 23% annualised, whereas bonds appreciate by an average of 3.7%. The alchemy of risk parity leverages bond risk to the same level as equities, so that they deliver almost 14% annualised in these conditions.
So what happens when the carefully planned generosity of central bankers finally gives the economy momentum enough to restart growth? This is the big question sceptics pose the purveyors of risk parity. To those doubters, it does not seem possible to make money when bond yields are at rock bottom. Untrue, counters Bridgewater. Yes, stocks have done well during these ‘beautiful' deleveragings, but bonds can all but match them (with the aid of about the same leverage as that found in the typical public company - 2:1 debt-to-equity).
Fundamental to the claim is the steepness of the yield curve: central banks have to keep short-term rates low to continue stimulating the economy, a policy which can last 10-20 years, according to Prince. He points out that the US Federal Reserve carried on printing money from 1933 until 1947 after the Great Depression (financing military expenditure for the Second World War was one major reason).
This brings the first anomaly - that interest rates remain lower than nominal growth rates. The yield curve remains steep as the markets discount a rise in rates that fails to assert itself because of the central bank's continuing obligation to provide liquidity. If one believes this, the smart thing to do is play the yield curve by rolling down it. What the sceptics ought to concentrate on, therefore, is not the absolute numbers involved - yields at the long-end will not be great - but the yields relative to the expected return on cash. This carry can always be enhanced by leverage and is one way out of markets' sideways shuffle.
Prince reckons that within Europe the All Weather strategy is most popular in northern Europe. Indeed, Denmark's ATP is a well-known exponent of a variation on the risk-parity idea in its return-oriented portfolio. Some UK, Danish, Dutch and Swedish pension funds might, however, question whether the leveraged duration bet that risk parity involves makes sense if they have leveraged duration bets already in place via the swaps in their LDI portfolios. Prince responds that funds with liability hedges are definitely a step ahead in managing their risks. However, their asset portfolios still need to be re-weighted.
If you believe Bridgewater, this could be a ‘beautiful' deleveraging, indeed.