Lifting the lid on Ray Dalio’s Pure Alpha fund

Hedge fund billionaire Ray Dalio is a legend among investors. Not only has he built Bridgewater Associates into the largest hedge fund firm in the world over the past four decades, managing about $160bn in assets, but he has made himself into the world’s wealthiest hedge fund manager.

According to Institutional Investor, Dalio is estimated to have earned $2bn last year, a considerable increase from the $1.3bn he earned in 2017, giving him a reported net worth of $18.7bn in October 2019. 

One of Ray Dalio's keys to success has been starting one of Bridgewater’s flagship funds, Pure Alpha, which unlike Bridgewater’s low risk All Weather investment strategy makes bets based on the direction of global economic trends. 

The Pure Alpha fund operates under the standard two-and-twenty fee structure and as one of the first hedge funds to embrace quantitative analysis, Bridgewater bases nearly all of its trades on algorithms derived from decades of market observations. Since the Pure Alpha fund was established in 1991 and 2017, it has made investors an annual average return after fees of about 11.9%, New York Times analysis shows, outperforming the average yearly return of both the S&P 500 at 9.5% and the All Weather fund at 7.9%. 

Even in 2008 when most funds were experiencing unparalleled volatility, Pure Alpha managed to rise in value by 9.5% after fees, and the following year generated the highest return of any hedge fund after rising 45%, the New Yorker notes.

Ray Dalio's Pure Alpha misses 2019 market comeback 

This year, however, has proven to be a different story, as the fund has suffered one of its worst first-half performances in two decades – The Financial Times reported in July that Pure Alpha declined 4.9% in the six months to June.

What had reportedly started as a miscalculation on whether global equity and bond markets would bounce back following the 2018 sell-off went on to be fuelled by bearish wagers on global interest rates, Bloomberg’s Annie Massa says. The H1 decline continued and by the end of August the fund was down 6%. 

In a CNBC interview in August, Dalio had predicted that there was a 40% chance of a recession in the next two years. His thinking was that central banks wouldn’t have any leverage left if they were to keep lowering interest rates. 

However, the Fed in fact pursued a hawkish stance on interest rates, with two rate cuts since July. This echoed around the world with many other central banks launching stimulus programmes throughout the year, leaving Dalio on the wrong side of the rates trade. 

“Everyone makes mistakes” Dalio Tweeted following in August. “The main difference is that successful people learn from them and unsuccessful people don’t. By creating an environment in which it's okay to safely make mistakes so that people can learn from them, you’ll see rapid progress and fewer significant mistakes.”

“Everyone makes mistakes ... The main difference is that successful people learn from them and unsuccessful people don’t” - Ray Dalio

This wasn’t the first time Dalio’s bearishness cost him. The New Yorker recalls that back in 2009, Dalio had predicted that the US economy’s recovery after the financial crash would be weak but when growth rebounded from stimulus actions the Pure Alpha fund faltered. 

Dalio does still think that a recession is likely, however he has adjusted his estimate since August, telling Bloomberg earlier this month that he now thinks there is about 25% chance.

Ray Dalio’s macro investing strategy

The last two years has seen many funds dragged down by market turbulence, particularly during the December 2018 sell-off. During this time the industry lost 4.1% for the year – its biggest loss since 2011, according to Hedge Fund Research.

Bridgewater’s Pure Alpha fund has been the exception. In 2018, the fund managed to post returns that not only outperformed nearly every major asset class, from global stocks to government debt and corporate bonds, but also many of its peers. 

While the average hedge fund lost 2% in the 11 months to November 2018 and the S&P 500 ended the year down 7%, Pure Alpha posted a 14.6% return for the year, reportedly marking its best performance in five years – with a net gain of $8.1bn, according to MarketWatch analysis.

The fund’s success came down to the predicting of a slowdown in the market, as Bridgewater’s co-chief investment officer Bob Prince suggested in an interview with the Financial Times in October 2018.
 
“We are clearly shifting from an era of monetary easing to monetary tightening,” Prince said. “A lot of optimism about future earnings growth has been baked into equity valuations. But we are at a potential inflection point where the economy is moving from hot to mediocre.” 

With the exception of Prince’s comments, Bridgewater famously doesn’t reveal its investment strategy, although overtime Dalio has given some insight into his investment methods. One approach he takes is by spreading his bets in what is sometimes referred to as “portable alpha”. 

The strategy means that the Pure Alpha fund has in place about thirty or forty different trades at any given moment.  “I’m always trying to figure out my probability of knowing,” Dalio told the New Yorker back in 2011. “Given that I’m never sure, I don’t want to have any concentrated bets.”

A tried-and-tested investment philosophy 

There are few investors who are able to predict how quickly the narrative can change from a global market recovery to a global market slowdown, making Dalio’s Pure Alpha fund a real success story. 

Since stepping back from management in 2017, Dalio has spent more time sharing his unique investment philosophy through his books, which began with ‘Principles: Life and Work’ – a white book on his observations about how markets work. 

“The challenges you face will test and strengthen you,” he wrote on Facebook in July 2018. “If you're not failing, you're not pushing your limits, and if you're not pushing your limits, you're not maximising your potential."