As regular readers know, we are big fans of Bridgewater Associates. Their quintessentially “alpha-centric” view of the world amounts to a case study in modern portoflio management. The firm put out an interesting note in January that was recently brought to our attention by blog wonderkid Yaser Anwar over at investmentideas.blogspot.com.
The following excerpt succinctly sums up the philosophy shared by $100b+ Bridgewater and the somewhat smaller, but no less enthusiastic, AllAboutAlpha.com:
“As you know, we generally view the move into hedge funds as part of the evolution of money management. As we have described for many years now, the investment world should, and will, evolve towards a world of separating passive investment decisions (we call them beta) from active investment decisions (alpha). Most institutional investors continue to tie together their alpha and beta decisions (i.e. an institution typically decides how much money they want in equities and then goes out and hires equity managers to manage it). This is clearly inefficient, as the two decisions need not be linked.”
But this article isn’t just about Bridgewater’s view of combining alpha and beta. It’s about alternative beta, or to put it negatively as they have, “selling beta at alpha prices”.
The firm reviews several hedge fund strategies – fixed income arbitrage, convertible arbitrage, emerging market, distressed, and long/short equity – and specifically identifies the alternative (or in some cases, traditional) betas inherent in them.
Bridgewater says that fixed income arbitrage funds can be replicated by going long illiquid instruments, long high-yield currencies (i.e. carry trade), and short volatility (e.g. selling options).
Convertible arbitrage, says the firm, can be replicated by its three underlying components: credit, volatility and equity. A shortage of converts, it says, has reduced the premium to be gained above and beyond these basic underlying factors.
Finally, Emerging market and distressed debt hedge funds, says Bridgewater, aren’t much more than combinations of emerging market equity and debt and junk bonds – which should come as no surprise, really, since that’s what these funds invest in (why do we even call these “hedge funds” anyway?).
Regardless of their fees, Bridgewater also questions hedge funds’ ability to produce returns in what they call “rising risk environments”. They map cumulative hedge fund returns to periods of risk (defined using proprietary measures) and show that hedge fund returns are flat during these times (which, we suggest, isn’t actually that shabby).
But perhaps the most seemingly alarming concern raised by Bridgewater about the hedge fund industry is the amount of leverage being applied today in order to get returns to a point where they become attractive. Check out their chart:
Yikes. Apparently prime brokerages started giving away money to everybody sometime in Q4, 2003. But wait. Before we all dive under our desks for cover, note that leverage was routinely around 200% until 2001. And according to this chart it’s now back at around 200%.
Clearly, Bridgewater is trying to distance itself from the hedge fund community. So it’s probably too bad that New York Magazine just named Bridgewater CEO, Ray Dalio as one of America’s top ranked hedge fund managers (under the category “braniacs”).