Bridgewater’s co-CEO tells Christopher O’Dea about some of the misconceptions regarding risk parity
- Bridgewater’s All Weather portfolio balances growth, inflation, discount rates and risk premia
- The difference between bond yields and bond financing costs is critical to understanding risk parity strategies
- Bond investors face asymmetric risks because the Fed has little leeway to tighten policy without triggering a downturn
- Institutions are working with Bridgewater to apply the All Weather concept to entire portfolios
Any navigator who’s charted an ocean crossing knows that the shortest distance between two points is a straight line. But practical experience also teaches that storms, tides, wind and plain old dumb luck can push even the best-piloted vessel off course from time to time.
Successful voyagers are the ones who prepare their ships to endure the inevitable variation in the environment, and steady the helm with sufficient rigour to make course corrections before veering too far from the desired bearing.
Those, in effect, are the principles that guide the All Weather strategy managed by Bridgewater Associates, the $160bn (€135bn) investment management firm founded by Ray Dalio. Dalio and his team launched the All Weather strategy in 1996, predicated on the notion that asset classes behave in ways best understood by the relationship of their respective cash flows to the economic environment. By balancing assets based on these structural characteristics, the impact of economic surprises on the portfolio can be minimised.
“The concept was so simple that we didn’t even think it should be a product,” says Bridgewater co-CIO Bob Prince. Dalio, Prince and other members of the Bridgewater team devised the All Weather strategy to manage the assets in Dalio’s personal trust. “We wondered why anybody would pay us to do that, because all they have to do is look at what we hold and they could do it themselves,” says Prince. “But that turned out not to be the case.” In fact, many investors took a pass on the do-it-yourself opportunity, and today Bridgewater manages $77bn in the All Weather strategy.
Prince recently spoke with IPE from Bridgewater’s Connecticut headquarters, discussing some of the misunderstandings that persist about risk-balanced asset allocation even as so-called ‘risk parity’ strategies have proliferated, the potential effects of rising interest rates on risk parity and other assets, and how Bridgewater works with institutional clients to apply the All Weather concept to their entire portfolios. A discussion with Bob Prince makes clear that investing, at least to Bridgewater’s way of thinking, remains a straightforward matter of balancing the effects of growth, inflation, discount rates and risk premia on the assets available in global markets.
“If you think in terms of causal influences on cash flows, most every asset in the world can be described according to its exposures to four things,” says Prince. “You have growth assets and inflation assets, then you have discount rates and risk premiums, and that’s really all there is,” he says. “That’s the reality of the world.”
Know what you’re earning
With current financial headlines chock full of news about imminent interest rate increases, Prince says it is important for investors to understand two key points – precisely what their bond portfolios are earning, and the underlying driver of any rise in interest rates that might ensue in the months ahead.
“Probably the biggest misunderstanding people have about risk parity is that what you’re really doing, when you’re holding a bond, is that you’re earning the bond yield, but you’re paying the financing rate at the repo rate,” says Prince. As an investor, “you’re really earning the difference between the bond return and the cash return,” he says, adding, for emphasis: “You’re not just earning the bond return. You’re earning the difference.”
Prince highlights a key point: “That difference can be the same, no matter what the level of interest rates.” If a bond yields 14% and the cash rate is 12%, that difference is two, while if a bond yields 2% and the cash rate is zero, the difference is still two. That excess return comes on top of whatever the risk-free rate is – in one case 12%, in the other case zero. But investors must understand that the risk-free rate “has got nothing to do with risk parity,” Prince says. “It’s just what it is, and it gets priced into all assets.”
What’s driving returns?
Bearing in mind the importance of excess return over risk-free rates, the key factor for investors to evaluate with respect to the interest rate environment is the underlying driver of any rate changes. Aggressive tightening of monetary policy would hurt the returns of risk parity because such a policy change would reduce liquidity in the financial system and raise the discount rate on future cash flows from all assets, Prince says. “If you’re holding a portfolio of all assets, when you get an aggressive tightening of monetary policy, it’s going to go down.”
However, Prince notes: “A rise in interest rates is not necessarily going to be a tightening of policy.” If the pace of nominal GDP is increasing more rapidly than interest rates are rising, for example, then cash flows and debt service ability are improving faster than the interest rate cost of funding. “So actually, things are getting better, not tighter,” Prince says. Similarly, if an interest rate increase were being led by a rise in long-term rates, “then the central bank is just lagging behind, and that’s not really a tightening, that’s just the central bank keeping up.”
In short, the impact of a rise in rates depends on what causes the increase. Gradual increases in interest rates when inflation is rising might detract from fixed-income performance, as would a rise in real interest rates from strong economic growth. In those scenarios, some buckets of a diversified mix of assets would perform well to offset weakness in bonds. A diversified portfolio is preferable even in the extreme case of an aggressive tightening that reduces liquidity, Prince says. In that situation, “you don’t really gain anything by not being diversified because the individual assets all decline, but in the case of a gradual interest rate rise that drives other sources of returns in your portfolio, you do gain a lot by being diversified.”
Although the All Weather strategy holds a diversified portfolio of assets selected to balance out to an excess return of approximately 6% over the long term, Bridgewater eschews the risk parity moniker. “When I’m talking about risk parity, I can’t speak for the whole world,” says Prince. “I can only speak for what we do and the basic concept of a balanced diversified asset mix.” At Bridgewater, he explains, “we balance a portfolio’s exposure to growth and inflation, so that you neutralise those forces from the economic cycle.”
Having done that, he says, “you’re still going to have some variability in returns related to tight and easy money. In times of easy money you’re going to do better, and in times of tight money you’re going to do worse. But that tends to be short-lived because if you have a poor return under tightening liquidity, you typically get a slowdown in the economy and the central banks will then produce liquidity.”
Since it’s not possible to know when the economy will be in an expansion or a contraction, Bridgewater opts for a passive implementation. “There’s no active management,” says Prince. “The basic idea of All Weather, as we do it, is to determine what set of assets you would hold if you don’t have a view about what’s going to happen,” he adds. “It’s a balanced portfolio that should cruise through all environments reasonably well, but it’s a strategic asset mix and it’s entirely passive.”
Not all risk parity managers remain passive; some adjust strategies as volatility shifts, or make active bets seeking alpha. “We don’t do that,” says Prince. “All Weather is purely a passive portfolio meant to extract and earn the risk premium that’s embedded across all assets, with a diversification to dampen the effects, or neutralise the effects, of economic cycles and inflation cycles, which is most of what drives the volatility of assets, in order to produce more consistent returns over time.”
In practice, Bridgewater allocates an equal amount of risk to each of four portfolios that comprise the All Weather strategy (see figure). One is designed to perform well when economic growth is rising – that is, better than is discounted in market expectations, carrying a positive beta to growth. A second portfolio is exposed to falling growth, carrying a negative beta to growth. “On average, you’re going to cancel out the effect of growth,” says Prince. “But you’re going to earn the risk premium that’s in all those assets.”
Likewise, 25% of the assets are in a custom portfolio that’s designed to do well when inflation goes up, an inflation-tracking portfolio with a positive beta to inflation, and the final 25% of the risk is allocated to an inflation-tracking portfolio with a negative beta to inflation. “That’s what we do,” says Prince, modestly. “We just have those four portfolios, we have assets in there, and that’s it.”
Spreading the word
But just as there’s more to crossing an ocean than reading a navigation book, implementing the All Weather concept in an actual portfolio requires hands-on training, and Bridgewater increasingly finds itself helping clients plot their own courses.
“The portfolio is just how we apply the All Weather concept,” says Prince. “We work with our institutional clients to help them apply that concept to their portfolios and their assets. It’s really universal because growth and inflation affect everything. The balancing into the four portfolios is the main objective, and we help our clients apply those basic concepts.”
Eye on the horizon
While not positioning the portfolio to respond to any particular events, investors will continue to face challenges. At the moment, a long-term debt cycle relating to leverage and economic growth is playing out, Prince explains. In the US “we are starting an economic expansion from a very high level of debt,” he says. “Because of that, the economy has been much less responsive to interest rate decreases and will be more responsive to interest rate increases.”
Prince continues: “Going forward, the asymmetry of monetary policy is very important to understand. The average amount of interest rate cuts required to reverse an economic downturn has been about 500bps. That was during normal economic environments, during what we call a long-term debt cycle up wave.” Today the Federal Reserve has less leeway. “If you started a downturn with interest rates this low, you don’t have 500bps,” Prince explains. The risk to investors is that the Fed’s “ability to tighten and trigger a downturn is not limited, at all, but the ability to ease and reverse one is severely limited”.
Given that macro environment, and the virtual certainty that the macro backdrop will continue fluctuate without advance notice, an investment plan for all seasons has a certain appeal. “Every asset, in the world, can be put in one of those four boxes,” Prince says. And he hasn’t given up on the DIY pitch. “Any investor can take this template and apply it to their portfolio to improve the diversification and the return-to-risk ratio of their portfolio.”
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