Derivatives Strategy - October'2000: The World According to Ray...

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The World According to Ray Dalio

Ray Dalio is the founder and chairman of Bridgewater Associates, a $30 billion global bond allocator,
currency overlay adviser, and hedge fund manager based in Westport, Conn. A preeminent expert on global
capital flows, he is highly regarded by the pension fund community. In an era when Julian Robertson and
George Soros are in full retreat, Dalio may be the largest macro-fundamentalist money manager still
standing. He spoke with senior editor Barclay Leib in September.

Derivatives Strategy: You are managing $30 billion now. Can you walk me through how you
evolved from having nothing to having this much money under management?
Ray Dalio: When I started Bridgewater in 1975, I had just left Shearson where I was in charge of
institutional hedging strategies. I loved the game of the markets. Bridgewater started off managing
institutional hedging exposuresmostly interest rate and currency risks, but also some commodity
risks. I also sent clients a daily fax (which back then was a telex) to explain the thinking behind my
moves in the markets. We started to sell it to others, and many people ended up knowing us
through that. In 1985, global investing started to become popular and I changed the focus of the
business from managing the currency and interest rate exposures of corporate hedgers to
managing global bonds and currencies for institutional investors. Bridgewater always managed
currency and interest rates. In 1985 we just changed who we did it for. This led to the firm's
evolution into its current form.
DS: Can you break down your various businesses as they currently exist?
RD: Of the $30 billion under management, $27 billion is split pretty evenly between currency
overlay and bond management, and $3 billion is in a hedge fund-like mandate. The bond half
consists of global bonds, inflation-indexed bonds and emerging-market debt, in different mandates
tailored to what our clients want. The currency management is also structured to what they want.
The hedge-fund type piece, which we call Pure Alpha, allows us to manage the money any way we
think is best.
DS: What do you attribute your extraordinary growth to?
RD: People, process and performance. Initially, performance is the biggest factor. Our numbers
have brought us some attention. We've been the number one global bond manager in the country
over the last five years, according to PIPER, which is sort of the Lipper Analytics of the institutional
investment world. We've been told that our currency performance has been the best over long-time
horizons. And the performance of Pure Alpha has been great, touch wood. But institutional
investors don't just buy performancethey dig beneath the surface. I'm blessed to work with an
extraordinary team of people. Also, worry has helped. We are always so worried about something
going wrong that we give as much attention to the game of defense as to our offensive game. So
we haven't had bad problems over the last 25 years. Nowadays, institutional investors appreciate
our risk controls even more than they did in the pastbefore certain high-profile firms got into
trouble.
DS: How do you make your money?
RD: Most of our global bond and currency overlay accounts are managed on a fixed fee, although
we try to get paid on incentive fees. The other $3 billion devoted to our classic macro hedge fund
strategy pays a 1 percent management fee and a 20 percent incentive fee. The assets in that
strategy aren't commingled in a fund because large institutions typically want their accounts
managed separately. The average account is about $100 million, so we find that this fee structure
works for everyone. Even though Pure Alpha accounts for only about 10 percent of our assets, it
accounts for most of our revenue because of the incentive fees.

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"My guess is that maybe 10 percent of all

institutional investors who should do currency
hedging are doing it.

DS: And for the currency overlay and global bond portions, you get about 25 basis points to beat a
benchmark?
RD: Fixed fees typically are in that range or slightly higher. And yes, we are measured against a
benchmark. Each client sets his or her own benchmark and we manage to it, replicating the
benchmark passively and managing around it actively.
DS: There are so many different benchmarkslong-term, short-term, hedged vs. absolute returns.
From a system point of view, how do you handle all that?
RD: There are two dimensions to thishow we handle this thinking-wise, and how we handle it
implementation-wise.
Thinking-wise, we always start with the client's benchmark as our neutral position. So whatever he
specifies as a benchmark is the position we will passively be at. Any deviations from that
benchmark come from our active bets against that benchmark. A typical client will give us
constraints, a certain leeway, expressing a risk preferencea 3 percent tracking error or a 5
percent tracking error, for example. These vary a great deal by client.
"We know where the ranges of volatility have
been, and what the volatility curves look like,
but that doesn't mean we can forecast what the
structure of the volatility curves will look like in
the future.

In terms of implementation, it's all systematized and overseen carefully. We will replicate the
benchmark for each account. We then program in the deviations allowed so those are hard-wired,
and we can never break a specified constraint. And we calibrate the aggressiveness of our
deviation from the benchmarks as a function of the constraints and tracking error they give us.
DS: So all this is done via computer, with automatic allocation to the different accounts as you
make strategic trading decisions?
RD: Right. The way we operateour views for the markets are of the same regardless of the
account. And those views are quantitatively expressed in terms of a degree. We calibrate our
views between -100 percent and +100 percent. So when we think about how bullish we are on a
market, we might say, "We are 32 percent bullish on the Aussie dollar. That's all done in the
research area, which comes up with the investment strategies and specifies these numbers. The
numbers are passed to the trading area, where the mandate is programmed, so the signals can be
converted into desired portfolios and the transactions needed to get them there can be done. The
numbers expressing our market views, such as +32 percent, are input into a client-specific
template, which basically says that this client has this benchmark, this constraint, and so we need
to do these trades. The trading department exercises them. We have great reporting systems, so
we can see this transpiring from our desktops.
DS: In your estimation, what percentage of international bond and equity investors still don't do any
currency hedging at all?
RD: The overwhelming vast majoritybut I don't know exactly what that number is. My guess is
that maybe 10 percent of all institutional investors who should do currency hedging are doing it,
although the number is growing rapidly.
DS: And this general dearth of hedging is a mistake?
RD: Yes. There have been numerous studies done by pension consultants such as Frank Russell,

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Watson Wyatt and Towers Perrin showing that currency-hedging strategies have the effect of both
reducing risk and raising returns.
DS: Do you use a great deal of over-the-counter derivatives in your hedging activities, perhaps
when you are trying to meet an options benchmark?
RD: No. Even if a client gives us an options benchmark, we hedge it dynamically rather than cover
the exposure with an OTC option. We'll certainly consider the relative costs of those two paths.
But we typically stay away from exchange-traded or OTC options because we are never sure
about the liquidity of getting in and out of those products for the size we need.
We also don't tend to replace straight positions with options positions, because we have no
particular value-added capability in forecasting implied volatility. We know where the ranges of
volatility have been, and what the volatility curves look like, but that doesn't mean we can forecast
what the structure of the volatility curves will look like in the future. If I tried to play that game with
the research we have, it would yield a very poor Sharpe Ratio.
DS: But when a client gives you an options benchmark and you hedge it away through dynamic
hedging, you have some embedded risk of jump moves and illiquid markets, and of not being able
to hedge. If you don't explicitly buy options, how do you handle the risk of black holes of illiquidity?
RD: Life is filled with trade-offs. That is one of the risks of dynamically hedging.
DS: Do you consider Bridgewater a dynamic hedger?
RD: No. We will only do it when a customer gives us an options mandate, which is infrequently.
What is more important here is simply to make sure that we don't have a concentration of risks
that we can be squeezed out ofto make sure there's enough diversification so we can't be
whacked. We're playing probabilitieswhich isn't much different from what an insurance company
does.
DS: But isn't subcontracting the insurance sometimes a good idea?
RD: Sure, but here's the point. If you're insuring five people against heart attacks, and then you lay
off that exposure, you're not going to improve your financial results. The only way you're going to
improve your results is by insuring 5,000 people, and getting better diversification. Our positions
are usually so diversified that a black hole of illiquidity in one market isn't going to hurt us much.
DS: Over the years you've evolved from a fundamentalist to someone with a systematized trading
model. That's a pretty big change I suppose. How did that happen?
RD: I just systematized my fundamental rules. When I was making discretionary decisions, I
decided as a discipline to write down the reason for each decision. So I did that, and all these
different reasons accumulated. Then I realized that if I could be very specific and clarify those
reasons, I could test them across different countries, different environments, and so on. For
example, rather than just make a decision that I should buy the U.S. dollar and short the euro
because U.S. productivity is strong in relationship to European productivity, I could study all the
different productivity differences and relationships, develop the strategy, develop a rule, and build a
track record.
DS: Did you optimize some of these rules along the way?
RD: I learned from experience that it is extremely easy to find rules that made a lot of money in the
past. But I have to have a logical context to protect me against data-mining. There's a saying, "If
you put enough monkeys in front of typewriters, one of them will come up with Shakespeare.
When you think of the investment business, you could test a random indicator that has a 50
percent chance of making money. Now, if you check a large number of rules, you can absolutely be
assured to find a lot of indicators that look like they work, but aren't necessarily robust. And the
only thing that helps you out is not starting with the testing program. You don't go looking for

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answers. You need to have a hypothesis about what you already think, before you go test. That is
why I believe in fundamentals. We build our systems around them, not optimized outcomes.
DS: Do you ever fundamentally question your own models' output?
RD: All the time. But you've asked that question the wrong way around. Our models' output is just
our own thinking that has been calculated by the computer. So do we ever question our own
thinking? Sure. You have to understand that we are fundamentally based, qualitative managers
who have just used the computer as an effective tool to check out our thinking and to process
information quickly. We reconcile what's coming out of the computer with what we think every day.
And whenever they differ, we reconcile them. My question is never "Is the computer right or
wrong? but whether my original instructions to the computer were right.
"What is more important is to make sure that we
don't have a concentration of risks that we can
be squeezed out ofto make sure there's
enough diversification so we can't be whacked.

DS: How often do you ask that question?

RD: All the time. Of course, we also have certain red flags. By having rules, we can figure out the
expected track record based on those rules, and see if there are deviations of actual performance
from the expected performance. A deviation would be a red flag. We manage money by thinking
about the markets. And then we say, "Does that measure up against what we told the computer?
Was the computer given the right set of instructions?
DS: Let's shift to macro economic issues. Are we at the end of a typical late cyclewith an
inverted yield curve, strong dollar and strong oil market, and the economy ready to roll over and
die? Is it a typical late cycle or an atypical late cycle, or is it not a late cycle at all?
RD: I think we are in the early part of the late cycle. Late cycles are reflected, most importantly,
by the magnitude of inflation pressures you're actually feeling. Central banks tighten to fight
inflation and the last stage of an expansion is when they tighten. Recessions occur because central
banks over-tighten. There has never been a recession that was not preceded by a central bank
tightening. The current magnitudes of inflation and the tightenings do not suggest that the Fed is in
a corner and needs to overdo anything. On the other hand, the economy is more sensitive to Fed
moves.
DS: Couldn't a final incremental pea-shift topple the entire mountain?
RD: If you had asked me a year ago, I wouldn't have been as concerned, because there wasn't as
much leverage in the system. Recently, there has been a major step up in leverage, and
particularly in M&A activity. The stock market has gone up, while individual household sectors have
been sellers. We estimate that 60 percent of the stock-market gains are attributed to company
purchases of other companies or of their own stock. What we have seen in the last 18 months in
M&A is heavily debt-financed, particularly European purchases of American business. Because of
that, there is a greater sensitivity to a rate change. If you have twice as much debt, and you raise
interest rates by 1 percent it has twice the impact than if you had half as much debt and you raised
interest rates by 1 percent. So not only do you have the speculative element, but also because of
these equity merger activities, a tightening of Fed policy will have a greater sensitivity and impact.
DS: Is this corporate proclivity to purchase stock and finance with debt going to turn into a fiasco?
RD: It is creating large asset-liability mismatches that are very dangerous, particularly when the
money being borrowed is in one currency and the assets being bought are in another, as has
recently been the case. European purchases of American companies have typically not been on a
currency-hedged basis. Systematically, through history, there has been a tendency for companies
to borrow wherever interest rates are lowest, particularly if that currency has been weak. People
say, "I'm going to borrow in this trashy currency that goes down all the time, and I'm going to pay a
lower interest rate. Over time, this has probably been the cause of more debt problems than any

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other single factor.

The current flows are extraordinary and certainly not sustainable. The Germans have been
particularly aggressive in cross-border purchases that have been financed in euros. You can't have
debt-financed, German M&A purchases equal to 8 percent of their gross domestic product each
year forever. Of course, all debt-financed M&A activity has not been cross-border, but even on the
portion that is not, this activity has been huge and is risky. Corporate balance sheets are now very
sensitive to central bank tightenings.

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