Dalio Patched All Weather’s Rate Risk as U.S. Bonds Fell
As the bond market plunged in late June, Ray Dalio convened the clients of Bridgewater Associates LP, the world’s largest hedge-fund manager, to tell them that a fund designed to withstand a broad range of market scenarios was too vulnerable to changes in interest rates.
Bridgewater, citing months of study, said it had underestimated the interest-rate sensitivity of various assets in its All Weather fund and was taking steps to mitigate the risk, according to clients who listened to or read a transcript of the June 24 call. By the end of the month, the Westport, Connecticut-based firm had sold off enough Treasuries and inflation-linked bonds to help reduce the fund’s most rate-sensitive assets by $37 billion, according to fund documents and data provided by investors.
The move, disclosed to investors five days after the Federal Reserve said it’s prepared to phase out its unprecedented bond purchases, was unusual for the fund. As its name suggests, All Weather is designed to produce returns in most economic environments and avoid altering asset allocations when the outlook changes. All Weather incurred a second-quarter loss of 8.4 percent that was primarily tied to its $56 billion portfolio of inflation-linked debt, said the clients, who asked not to be named because the fund is private.
The decline at All Weather and similar funds, including those run by Cliff Asness’s AQR Capital Management LLC and Invesco Ltd. (IVZ), shows Bridgewater’s pioneering strategy for allocating assets between stocks and bonds, known as risk parity, can leave investors overexposed to rising interest rates. The losses were amplified for some funds by a selloff in inflation-linked securities that also caught Bill Gross’s $262 billion Pimco Total Return Fund (PTTRX) off guard.
“This is just a foretaste of what is going to happen,” said Ramin Nakisa, a global asset-allocation strategist at UBS Investment Bank who co-wrote a March research report titled “When Risk Parity Goes Wrong.” Nakisa called June’s selloff in Treasuries and inflation-linked bonds “a dress rehearsal” for the volatility awaiting when the U.S. Federal Reserve actually begins to taper its bond-buying program, known as quantitative easing.
Bridgewater sold Treasuries and related futures contracts to reduce exposure to nominal interest rates and sold TIPS to address the extra exposure to inflation-adjusted, or real, rates, according to four All Weather clients.
The sales were the result of longer-term research and not a reaction to the changing market outlook, said a person familiar with the firm. Most of the sales occurred before real rates began to rise in May and June, said the person, asking not to be named because the fund (AQRIX) is private. Without the sales, All Weather’s second-quarter loss would have been 1.5 percentage points higher, this person said.
Parag Shah, a Bridgewater spokesman, declined to comment.
The changes mark the first time that Bridgewater has made a substantive change to All Weather since the strategy’s inception in 1996, said the person familiar with the firm. The revision will reduce All Weather’s volatility by about 20 percent over a three-to-five-year time frame without affecting the fund’s ability to meet its goal of outperforming annual returns on cash by 5 to 7 percentage points, this person said.
The firm had about $150 billion of net assets in two basic strategies as of early July. The $70 billion Pure Alpha fund is the flagship for making macroeconomic bets backed by extensive research. The passively run All Weather, which doesn’t make directional bets on or against markets, has grown faster in recent years, quadrupling to about $80 billion in assets since the end of 2009.
Originated by Dalio, 64, as a way to manage a family trust, Bridgewater spent decades developing All Weather into a formal strategy that seeks to balance the amount of risk that a portfolio derives from low-volatility assets such as bonds and commodities with that derived from more-volatile assets such as stocks. To do so, All Weather typically relies on leverage in the form of borrowed money or derivatives such as futures contracts to juice the potential returns from bonds.
The goal is to create a portfolio in which a quarter of the assets do well in each of four basic scenarios -- economic growth that is faster or slower than expected, and inflation that is lower or higher than forecast. While other investors might get surprised by inflation swings or a growth bust, “All Weather would chug along, providing attractive, relatively stable returns,” according to Bridgewater’s website.
That has usually been the case, with All Weather posting average annual returns of 9.3 percent from its June 1996 inception through March, according to a May 13 Bridgewater client presentation. That compares with 7 percent gains for a benchmark portfolio with 60 percent in equities and the remainder in bonds, the traditional institutional model that, according to risk-parity proponents, derives almost all of its risk and potential returns from stocks.
“The whole concept of balanced risk is you don’t have the volatility in your system entirely driven by the equity market,” said Larry Swartz, chief investment officer at the Fairfax County Retirement Systems in Fairfax, Virginia, an All Weather investor that uses risk-parity concepts for its whole portfolio. Stocks “really depend on increasing expectations of growth.”
Some traditional money managers such as Ben Inker, the director of asset allocation at Boston-based Grantham, Mayo, Van Otterloo & Co., have said risk parity owes much of its success to the tailwinds of a 30-year bond market rally, because the funds invest a large portion of their assets in debt and related instruments. Inker, in a March 2010 white paper, said the “beguiling combination of lower risk and higher return” that the strategy appears to offer is “largely an illusion.”
Excessive interest-rate risk has been “the chief complaint thrown at every risk-parity strategy for years and years,” said Thomas Lee, a senior portfolio manager at Clifton Group, a Minneapolis-based unit of Eaton Vance Corp. (EV) that provides clients with customized risk-parity products.
Robert Prince, Bridgewater’s co-chief investment officer, addressed such criticism in a Jan. 9 commentary, stating that rising interest rates generally stem from accelerating economic growth or increased inflation, environments in which All Weather’s bond losses would be offset by its profits on commodities and stocks.
The exception to this scenario, Prince wrote, would be a small “subset of cases” such as an extreme tightening of liquidity caused by the Fed or an implosion of the financial system in which all asset prices decline. The impact of those cases would be short-lived, he said.
Equity and fixed-income markets both had bouts of selling in May and June when Fed Chairman Ben S. Bernanke signaled that the central bank might phase out its latest quantitative easing program, the monthly purchases of $85 billion of bonds. Bernanke rattled investors with comments suggesting that the Fed was prepared to taper its stimulus program even though inflation remained below targets previously set by the central bank before it would begin tightening.
Bernanke’s words were “pretty radical,” said John Brynjolfsson, the chief investment officer of Armored Wolf LLC, an Irvine, California-based money manager whose specialties include TIPS and commodities. “The implication is that he would be comfortable with inflation being below target rather than keeping his foot on the gas pedal until inflation exceeded the target.”
The second-quarter losses fell particularly hard on funds that had loaded up on Treasury Inflation Protected Securities, or TIPS, which typically provide protection if interest rates are pushed higher by expectations for accelerating inflation. That wasn’t the case in May and June, as interest rates moved higher in anticipation of reduced asset purchases by the Fed, while inflation expectations receded, leaving TIPS among the biggest losers.
The $1.2 billion AQR Risk Parity Fund, managed by Cliff Asness’s AQR Capital Management LLC, fell 9.6 percent last quarter. Invesco’s $23.5 billion Balanced-Risk Allocation Strategy, which had avoided TIPS, declined 5.5 percent, according to a performance update obtained by Bloomberg News.
The losses from the TIPS selloff also hurt some of the best-known traditional bond funds. Gross’s Pimco Total Return, the world’s largest mutual fund, declined 4.7 percent in May and June, also hurt by TIPS. Pacific Investment Management Co. in Newport Beach, California, which runs the fund, owned about 10 percent of the TIPS market, according to Morningstar Inc. (MORN)
All Weather’s exposure to Treasuries and other nominal bonds equaled 48 percent of net assets and its exposure to inflation-indexed debt, including TIPS, was 70 percent, according to the May presentation. Because of leverage, asset-class exposures totaled 173 percent of net assets.
The fund benefited from its TIPS holdings since the Fed, in a bid to drive down long-term interest rates, began the first of three asset purchase programs in late 2008. The moves pushed inflation-adjusted interest rates below zero for a sustained period. All Weather’s annual returns averaged 16 percent from 2010 through 2012, well above the strategy’s target return of 5 to 7 percentage points above cash.
That prompted Bridgewater to begin doing research earlier this year on why the fund’s returns were higher than expected, a project that led the firm’s principals to conclude All Weather had too much exposure to “real” yields, said the person familiar with the fund.
On the June 24 conference call, one day before the TIPS market fell to its lowest level in more than a year, Bridgewater said it hadn’t fully grasped the interest-rate sensitivity, or duration, for All Weather’s assets, according to people familiar with the discussion. As interest rates drop, stocks become more sensitive to the discount rate investors use to determine the present value of a company’s future cash streams.
Judging duration for equities is “messier” than it is for bonds, said Eric Sorensen, the chief executive officer of Boston-based PanAgora Asset Management Inc. That’s because a stock’s duration is also influenced by the type of company being examined and the reason rates are changing, said Sorensen, who co-wrote the 1989 article “A Total Differential Approach to Equity Duration” in the Financial Analysts Journal.
When inflationary pressures push rates up, bonds generally decline while stocks, particularly those of cyclical companies that can pass along price increases to customers, fare well, Sorensen said in an interview. This allows a risk-parity fund to offset fixed-income losses with equity gains.
Stocks and bonds have both fallen in response to rising rates on several occasions during the past two decades, Sorensen said. When the Fed unexpectedly raised its target Fed Funds rate in early 1994, for example, the Barclays U.S. Aggregate Index declined 3.9 percent during the first half of the year and the Standard & Poor’s 500 Index fell 3.4 percent, with reinvested dividends.
This year, the S&P 500 fell more than 4 percent between mid-May and late June, when Bernanke made separate comments on tapering the Fed’s quantitative easing, while the yield on 10-year Treasury notes rose above 2.5 percent for the first time in 22 months. TIPS declined 7.4 percent during the second quarter, their worst showing ever, according to the Bank of America Merrill Lynch U.S. Inflation Linked Treasury Index.
‘Time to Hedge’
“The time to hedge that kind of risk is not when the risk is upon you,” said Sorensen, adding that he was speaking in general terms with no knowledge of Bridgewater’s situation. “If you had been hedging throughout for the potential of stocks and bonds to have a high correlation” to rate movements, he said, “you wouldn’t have made as much money.”
Bridgewater had increased the amount of TIPS across its strategies after the Fed began quantitative easing in late 2009, according to financial statements filed with the U.S. Department of Labor. TIPS held by the Pure Alpha and All Weather funds that file reports with the Department of Labor surged to $21.6 billion, or 31 percent of net assets, at the end of 2011 from $6.9 billion, or 16 percent, at the end of 2009. Bridgewater’s 401(k) plan had 16 percent of assets in the Vanguard Inflation-Protected Securities Fund at the end of 2011.
“The most popular trade of the last year has been on the back of quantitative easing, that it has to drive up inflation at some point,” Woody Jay, a principal at CRT Capital Group LLC, based in in Stamford, Connecticut, said in an interview. “The trade was so one-sided, it’s not surprising that TIPS were overdone in the selloff,” said Jay, a former chairman of the committee of securities dealers that advises the U.S. Treasury on debt issues.
All Weather trimmed its use of leverage to about 144 percent of net assets at the end of June, according to the clients who requested anonymity. Gross exposures to different asset classes declined to about $116 billion from $138 billion in the quarter, while net assets stayed at $80 billion.
The fund’s exposure to Treasuries and other sovereign debt declined to about $14 billion from $38 billion, and its gross holdings in inflation-linked debt decreased to about $43 billion from $56 billion, based on figures from the May presentation and the two investors who requested anonymity. These declines reflect changes in market value as well as sales.
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