You know there’s a bear market lurking because Ray Dalio has been getting a lot of attention lately. Dalio, one of the richest and most successful investors on the planet, deserves to be listened to at all times, but especially when the markets are scared. That’s mainly because his company, Bridgewater Associates, which has about $140bn (£115bn) under management, is best known for putting the ‘hedge’ in hedge funds.
In a career now approaching 50 years, Dalio has built a net worth – depending on the source – of $15 billion to $20 billion. The actual amount is irrelevant; the number is simply to indicate that his understanding of the investment game is as good as it gets. Much of this understanding comes from deeper and deeper research into what powers global economies than anyone. Paul Volcker, former head of the Federal Reserve, the US central bank, suggested that Bridgewater had a bigger research department, producing better research, than the Fed. So it’s no surprise that when the Fed wanted to launch indexed bonds, it turned to Bridgewater for advice.
Dalio and Bridgewater combined can therefore create formidable complexity. Luckily, they can also distill their message into accessible simplicity and offer solutions for dealing with bear markets within reach of do-it-yourself investors. Their simplified, but not simplistic, view of investing is that the performance of any security depends on whether economic growth and inflation rise or fall relative to expectations. Indeed, as sophisticated as the analysis is, on issues related to stock performance, somewhere the pace of growth and inflation will be major factors.
Dalio suggests that most investors – institutional and retail investors alike – are vulnerable because their portfolios are too exposed to equities. That’s fine for dealing with inflation, but not for living with economic contraction, which – almost always – will come from unforeseen factors. Holding fixed rate bonds can solve this problem, but only to a certain extent. Clearly, if lack of growth combines with excessive inflation – just as 2022 demonstrates – then fixed income securities will also suffer.
Something more is needed that can cope with both faltering growth and rising inflation. This something is often a commodity. For example – as the 1970s, 1980s and today demonstrate – oil can be a partial hedge against slowing economic growth (admittedly, partly because oil pricing or supply constraints are holding back the economy in the first place). Gold can also do its job, especially as a counterweight to rising inflation.
Even better are inflation-linked bonds as they are almost guaranteed to perform well when inflation surprises on the upside. Thus, “linkers” become the fourth major component of what Bridgewater calls its All Weather Fund. This was launched in 1996 primarily as a vehicle to manage the Dalio family’s wealth without the need to hire expensive fund managers whose performance would be uncertain anyway.
Certainly, in the real world, the All Weather Fund uses leverage to generate its returns, a tactic often beyond the means of private investors due to the cost of borrowing. Costs aside, Dalio argued that investors should be less afraid to borrow. Indeed, with the appropriate level of leverage, returns on all assets can be made more or less the same. For example, it is intuitively easy to understand that if fixed-cost debt is partly used to finance a holding of government bonds, their returns will more closely resemble those of equities. Yet the process of equalizing returns in this way makes the performance of the portfolio less volatile than holding a conventional portfolio unmixed with bonds and stocks.
Several articles on the Bridgewater Associates website (www.bridgewater.com) explain the background to the fund and how it is constructed. The asset mix is shown in Table 1. Essentially, the fund is made up of four mini-portfolios rolled into one. Each has an equal weighting, made up of assets as shown in each quadrant of the table. So, for example, to benefit from expectations of increasing economic growth (see upper left quadrant), a portfolio will hold equal amounts of equities, commodities, and corporate and emerging market debt.
It should be noted that the overall composition of the fund does not change. It remains the same to be ready to face any eventuality that presents itself. That said, clearly – although perhaps largely theoretically – when investors feel more bullish or bearish, they can increase or decrease returns using debt.
There is also no right or wrong time to buy it. As a 2012 Bridgewater explanatory memo puts it, the fund “was born out of Bridgewater’s effort to make sense of the world, to hold the portfolio today that will do reasonably well in 20 years, even if no one can predict what form of growth or inflation will prevail”. At the same time, it guards against investors’ overconfidence that often “leads them to tinker with things they don’t deeply understand… With the All Weather approach, Bridgewater accepts that they don’t know what’s going on.” future in store for them and therefore choose to invest in long-term equilibrium”.
If the approach presented in Table 1 seems a little complicated, there is a simpler version of Bridgewater’s All Weather approach, managed by the Lazy Portfolio ETF website. The Ray Dalio All Weather Portfolio – so named, presumably, to distinguish it from Bridgewater’s original – uses only five US-oriented exchange-traded funds (ETFs) with weightings as shown in Table 2 claims an inflation-adjusted average return of 5.0% per year with a standard deviation of just 8% (in other words, two out of three years returns were between plus 13% and minus 3%). Over the past 10 years, returns have averaged 3% inflation-adjusted with a standard deviation of 6.4%.
|Table 2: Lazy Portfolio All Weather Funds|
|Long-term government bonds||40%|
|Medium Maturity Government Bonds||15%|
|Source: Lazy Portfolio ETFs|
Building an equivalent portfolio in the UK using ETFs exclusively would be straightforward. The necessary funds available on the London market are not lacking. However, it seems wise to add indexed gilts into the mix since iShares £ Indexed Gilts (INXG) is ready and waiting. Of course, dividing government bond holdings evenly between fixed interest and bond would not have helped portfolio returns over the past two years. Of course, that’s not the point. What matters is having the protection that indexing provides throughout an investment life and in all weathers.
Speaking of inflation, which we have been, the great Chicago School economist Milton Friedman famously noted that inflation is “always and everywhere a monetary phenomenon.” Of course, we can debate it, as many have. Discussions on inflation and the subject of money will never be far away. Yet, as to the extent to which messing with the cost and supply of money will affect the rate of inflation: everyone knows it will, but no one knows when and how much the effect will be felt. .
The Great Inflation of the 1920s, the one that did its best to undermine Germany’s Weimar Republic, is a case in point. Legend has it that the German government and central bank colluded to destroy the value of the mark to undo the cost of rebuilding France’s shattered post-1918 economy, which to the average German looked like more about retribution than reparations. It is true that it was a factor. Equally important, however, was the pent up purchasing power built up by the Germans during the 1914-18 war. This was invested in public debt, which had increased 20 times during the war, and in bank deposits, which had increased five times. When these liquid assets were turned into consumption, they stimulated their own inflationary feedback loop.
In other words, the rise in inflation was induced by inflation itself. Which raises the question of whether a mini Weimar Republic has not been created here in the UK by the perverse effects of Covid-19. The graph shows the correlation between UK money supply and its inflation rate where money supply is measured as the multiple of UK output (GDP). Thus, an increasing multiple shows that it takes more money to increase GDP by a given amount.
This multiplier peaked in 2010, after the 2008-2009 financial crisis, and again in 2020 when the government pumped money into the economy it had shut down. In both cases, inflation reacted, although this time with much more force. This is probably where supply side constraints and other real economy factors come into play. Who knows what spike in inflation this will take the UK to or when it will get there. All the more reason, one might think, for an all-weather approach to investing.