Ray Dalio’s How The Economic Machine Works

 

Ray Dalio is the legendary founder of the Bridgewater hedge fund which manages $US150 billion for the World Bank and pension fund clients. Dalio is influential for sharing his management principles that inform Bridgewater’s strategic subculture (PDF). He has now shared a 30-minute video on his personal model of global macro dynamics.

 

Maneet Ahuja has a chapter-length interview with Dalio in her book The Alpha Masters (Hoboken, NJ: John Wiley & Sons, 2012) in which he talks about how to learn; how he founded and built Bridgewater; dealing with the World Bank; and how to deal with crises:

 

If you’re limiting yourself to what you experienced, you are going to be in trouble. . . . I studied the Great Depression. I studied the Weimar Republic. I studied important events that didn’t happen to me. (p. 12).

 

Dalio says if you have 15 or more good, uncorrelated bets, you will improve your return to risk ratio by a factor of five. He calls this the holy grail of investing. “If you can do this thing successfully, you will make a fortune,” he says. “You’ll get the pot of gold at the end of the rainbow.” (p. 17).

29th February 2012: StratCap

Stratfor Logo

 

Strategic foresight practitioner Stephen McGrail pointed me to a Yes Men press release on Stratfor/Wikileaks, where I found this gem:

 

Among the millions of other leaked Stratfor emails are some that reveal dubious financial practices, including an apparent insider trading scheme with Goldman Sachs Managing Director Shea Morenz, who joined Stratfor’s board of directors and invested “substantially” more than $4 million in the scheme, called StratCap. “What StratCap will do is use our Stratfor’s intelligence and analysis to trade in a range of geopolitical instruments,” wrote Stratfor CEO George Friedman in September 2011. StratCap was designed through a complex offshore share structure to appear legally independent, but Friedman assured Stratfor staff otherwise: “Do not think of StratCap as an outside organisation. It will be integral… It will be useful to you… We are already working on mock portfolios and trades.” (StratCap has been due to launch in 2012, though that could now change.) [emphasis added]

 

I wrote about Stratfor/Wikileaks here. The StratCap documents are here. They reveal plans by Stratfor chief executive officer George Friedman and colleagues to establish an event arbitrage and global macro fund that would trade on the basis of Stratfor’s geopolitical and strategic intelligence. Friedman and colleagues envisioned a $US25 million fund with a 10% equity investment from Stratfor: small for global macro but possible for a boutique event arbitrage or special event fund. The emails deal with the fund’s offshore structure; the service agreement; the role and compensation of Shea Morenz; and Stratfor’s role to provide StratCap with actionable intelligence.

 

“From where I sit, this deal is dead,” Friedman wrote on 23rd July 2011. The deal show-stoppers included Friedman’s discontent with attorney Bruce Herzog‘s handling of the service agreement and anger over a $US200,000 fee (“for Bruce’s clumsy attempts to undermine the process”); an immediate tax liability that impacted on the initial investment capital; potentially adverse effects on Stratfor’s publishing business and working capital; and the potential for Shea and StratCap to bankrupt Stratfor through demanding potentially unlimited strategic intelligence. These show-stoppers made the deal non-viable: it exposed Stratfor to credit and transaction risks.

 

Friedman explained in his 23rd July 2011 email to Stratfor colleagues:

 

I can imagine easily a scenario in which StratCap’s demands outstrips Stratfor’s means to the point that StratCap would hold Stratfor in default and even push it into bankruptcy with StratCap the major creditor. Nothing in the course of the negotiations gives me the slightest hope that Bruce would not do this in a heart beat and that Shea wouldn’t let him. I regard the proposed service agreement as a threat to the survival of Stratfor as a company under Don and my control. [emphasis added]

 

Friedman notes: “I have no intention of being the Chairman of a failed investment fund . . . I will not be the public image of StratCap, ridiculed for the failure of an enterprise that was built to fail.” (A reference to Jim Collins and Jerry Porras’s influential management book Built to Last.)

 

StratCap may have run into other problems if the fund had launched. In 2002, Goldman Sachs paid a $US110 million fine to separate its sell-side research from Goldman’s trading activities. So did dotcom era analyst Henry Blodget. Morgan Stanley paid  $US125 million in fines though analyst Mary Meeker escaped prosecution. It’s possible that Friedman and Stratfor may have faced similar fines or regulatory threats if they had proceeded with the StratCap deal.

 

Want to start your own event arbitrage fund? You might start with Robert Webb’s Trading Catalysts (London: FT Books, 2006) and Andy Busch‘s World Event Trading (Hoboken, NJ: John Wiley & Sons, 2007) on event arbitrage and special event strategies. On hedge funds, read Sebastian Mallaby‘s excellent history More Money Than God (London: Penguin, 2011), and for the best academic research, Andrew Lo‘s Hedge Funds: An Analytic Perspective (Princeton: Princeton University Press, 2010).

Are Financialistas Over Hedge Fund Chic?

You can blame George Soros for making hedge funds the dark horse of the irrationally exuberant 1990s.

As the public face of the Quantum Group of Funds, Soros gained notoriety for short selling the English pound in September 1992 and allegedly making $1 billion in profits.  Adam Curtis observes in his riveting documentary The Mayfair Set (BBC, 1999) that Soros’ victory signalled the first time that market speculators had beaten a country’s central bank.  In the aftermath Soros cultivated a master trader persona based on his personal ‘theory of reflexivity’ or how ‘participant’s bias’ can shape our actions in and perceptions of market events.  Hedge fund chic arose in Wall Street as investment banks rushed to found hedge funds, which use leverage and pooled capital to manage assets, derivatives and securities for an investor group.

Financialistas however are showing signs of buyers’ remorse as subprime turbulence brings an end to Soros-inspired hedge fund chic.  The high-profile collapse of Bear Stearns‘ two hedge funds in mid 2007 was only a precursor, Hedge Fund Research notes, of 170 liquidated in early 2008.  The survivors have adopted Soros’ global macro strategy which relies on computational finance and dynamical models of currencies, interest rates and other macroeconomic factors to achieve returns.

Global macro is a risky strategy for several reasons: it requires forecasting models of complex interactions, computing power and fund mangers with impeccable judgment for asset allocation.  In fact global macro deals with a specific risk class known as systemic risk that results from business cycles and macroeconomic movements, thus it cannot be diversified away.  Add funds’ massive leverage of pooled securities, industry secrecy, little government regulation and hypercompetition between different funds and managers, and an accurate calculation of risk-return is difficult.  These challenges overshadow the potential of applied research solutions, such as Fritz Zwicky‘s morphological analysis, a problem-solving method which deals with ‘multi-dimensional, non-quantifiable problems’ – relevant to the macroeconomic factors and systemic risk in global macro strategies.

Hedge fund chic faces several other problems.  As an investment category hedge funds have matured and their combination of high leverage and high management fees are unsuitable for many non-institutional investors.  Subprime fallout is triggering change in US financial and regulatory institutions which will inevitably lead to more rules and regulatory oversight of edge funds and managers.  Internally, hedge funds also need to separate managerial processes (principal management, portfolio execution) from financial reporting (mark to market book) and governance (board, corporate and policies & procedures).

Which means despite Soros’ alchemical touch hedge fund chic may now be a fad.