Posted: June 16, 2023
Disclaimer
The Hatch Fund is not a registered investment, legal or tax advisor or a broker/dealer. All investment/financial opinions expressed by The Hatch Fund are from personal research, analysis and experience of the owner of the site, and are intended for educational purpose. Please conduct your own due diligence before relying on the opinions presented on the site for your investment use. If in doubt, please seek advice from your legal, financial, tax, or other professional adviser(s). In the event that you choose not to seek advice from such advisers, you should consider whether the product in question, or any course of action recommended, is suitable for you. While best efforts are made to ensure the quality of our content, The Hatch Fund will not be liable for any gains/losses arising out of any recommendations made.
As always, subscribe to our newsletter to get updates on the latest posts if you enjoy what you read! Your viewership is greatly appreciated!
Ray Dalio’s All-Weather Portfolio and the “Quadrants”
Introduction to Ray Dalio
Ray Dalio is an American billionaire investor and hedge fund manager. He is the founder of Bridgewater Associates, the world’s largest hedge fund firm. Ray Dalio has been a global macro investor for more than 50 years and is known for his innovative investment strategies and insights into the global economy.
Apart from founding the world’s largest hedge fund, Ray Dalio is also known for his philanthropic efforts and his publications as a student of the financial market.
What is the All-Weather Portfolio?
Ray Dalio’s All-Weather portfolio is an investment strategy based on the principles of risk parity and diversification across geographies, currencies and asset classes. It is a portfolio designed to perform well in various market conditions.
The genesis of the all-weather portfolio came from a thought exercise that Ray Dalio had with his co-CIO, Bob Prince. They wanted to know what kind of investment portfolio would perform well across all environments.
Together with others like Greg Jensen, Dan Bernstein at Bridgewater Associates, they created an investment strategy that aims to deliver consistent positive returns regardless of economics conditions. This was first created for Ray’s trust assets.
Key Principles Underlying the All-Weather Portfolio
The All-Weather Portfolio is built on a few key principles:
- Any return stream can be broken down into its component parts and analyzed more accurately by examining the underlying drivers of these individual parts.
-
The key for most investors is fixing their beta asset allocation (i.e., a “buy-and-hold” portfolio), instead of trading the market well.
Portfolio Return = Return on Cash + Beta (market return) + Alpha (selection / trading strategy)
Betas outperform cash over time; alpha is a zero-sum game, if you buy and I sell, only one of us can be right. When investing for the long-term, holding assets should provide a return above cash, and asset volatility is largely driven by how economic conditions unfold relative to current expectations (as well as how these expectations change).
- All assets have environmental biases – i.e., different asset classes (and industries) do well in different kinds of environment.
- Outside of commodities, most investors do not hold any assets that perform well when inflation surprises to the upside. Inflation-linked bonds fill this gap well, “backstopping” portfolio returns with some form of real return plus actual inflation.
-
Risk management is key – identifying a risk-neutral position, designing a hedging program and actively managing around the exposure to generate “alpha”.
For example, an equity-heavy portfolio exposes an investor to the risk that growth in the economy would be less than what is priced in by the market. To “hedge” this risk, equities have to be paired with another asset class that has a positive beta, but whose performance is, ideally, negatively correlated with equities (i.e., rises when equities fall)
- All asset classes have similar Sharpe ratios (return-to-risk ratio). Hence, the use of leverage can push returns of safer assets like nominal bonds to have similar expected returns as equities. (i.e., borrowing to buy bonds). Leverage should not be viewed as exotic as it is merely an implementation tool.
The Macroeconomic 2x2 Grid Framework
Defining the Types of Macroeconomic Environments
To map asset class outperformance in the different types of macroeconomic environment, we must first define the types of environments that can exist.
Ray Dalio sees four different types of investing environment – rising inflation, falling inflation, rising growth, falling growth – and uses a 2×2 grid to represent this framework. Each quadrant represents the market expectations of different macroeconomic environment in relation to how things actually unfold.
Source: Bridgewater Associates
The key drivers of asset price changes are (1) how economic conditions unfold in relation to current expectations, and (2) how expectations change over time. As such, Ray Dalio and his associates is able to capture both positive and negative surprises to current market expectations with this deceptively simple, yet effective, framework.
Source: Bridgewater Associates
By adopting this framework, Bridgewater Associates were able to map asset outperformance in different macroeconomic environments through their research and backtesting. The following assets were found to outperformance in the four different types of investing environments:
Rising Growth Environment
- Equities
- Commodities
- Corporate credit
- Emerging market (EM) credit
Falling Growth Environment:
- Nominal bonds (i.e., conventional bonds with fixed coupons)
- Inflation-linked (IL) bonds
Rising Inflation Environment:
- IL bonds
- Commodities
- Emerging market credit
Falling Inflation Environment:
- Equities
- Nominal bonds
These fall nicely in-line with Ray Dalio’s “Holy Grail of Investing” – diversification. According to research by Bridgewater Associates, a portfolio of ~20 assets with lowly correlated cashflows can cut out almost all the idiosyncratic risks (company-specific / industry-specific risks) from this portfolio.
Source: YouTube, Ray Dalio
Ray Dalio (and by extension Bridgewater Associate) believes that (1) assets generally go up over time, and (2) by holding to a portfolio of assets that performs well in different scenarios, an investor stands to grow his/her portfolio over time regardless of how economic conditions change.
In-line with the principle of diversification, the All-Weather portfolio aims to cover the ‘blindspots’ of investors by allocating across assets that perform well in different environment – when (1) inflation rises, (2) inflation falls, (3) growth rises, and (4) growth falls.
The All-Weather portfolio, in Bridgewater’s view, is what the average person needs – a good, reliable asset allocation to hold for the long-run. As Ray Dalio likes to say, “there is much more that we don’t know than we do”. One investor’s lifetime is too short to see the full picture of why things move. As such, our investment journeys are prone to ‘surprises’ that catch us off-guard. By holding assets that perform well in each type of scenario, investors can protect themselves against any unexpected downturns.
The Conventional Asset Allocation
In a conventional asset allocation (~60% equity and ~40% non-equity), the returns are almost entirely driven by the return on equities. While the portfolio may be balanced to 60/40 in dollar terms, investing in nominal bonds and other assets do very little to balance out the risk of a portfolio as they make up a small amount of risk.
Source: Bridgewater Associates
This can be seen from the extremely high correlation between the portfolio drawdowns and the equity component drawdowns of 0.96.
Source: Bridgewater Associates
Hence, when viewed from the perspective of volatility and cross-correlation of assets, the risk of a conventional portfolio is largely attributed to equities (represented by the red area in the chart above).
In effective, while the investor seems to have achieved broad diversification across asset classes in dollar amount, the associated risks and drawdowns reflect otherwise.
As such, the conventional portfolio is unable to perform well across different macroeconomic environments as its returns are largely driven by equities. This is a very interesting thought because most financial literature tell us that as long as investments are diversified across countries and asset classes, portfolio risk is minimized.
The untold part of the story is that while risk is minimized, the portfolio is still susceptible to drawdowns from unexpected economic surprises and changes in economic regimes – i.e., not protected in different macroeconomic environments.
Constructing the All-Weather Portfolio:
Using Leverage to Equalize Risk across Asset Classes
How then can one achieve true diversification?
This starts with first identifying the pool of assets that investors can invest in, and their respective risk-to-reward ratios.
Source: Bridgewater Associates
As taught in traditional finance theory, investors should expect to be compensated for taking additional risks. For example, by taking money out of your bank to invest in the stock market, you are exposing yourself to potential drops in the stock market in order to earn a return that is higher than what the banks pay out.
This is a recurring theme looking at the chart above:
- Debt and equity instruments have a higher expected return than cash because they bear greater risks;
- equities have a greater expected return than debt because they are riskier by nature of liquidation preference (seniority) and volatility of returns;
- emerging / non-US equities have a higher expected return than US equities because the relative stability of business climate in the US and the USD
- private equity has a higher expected return than listed equities given the illiquidity risks faced by investors (i.e., locked into a private equity investment vehicle for at least 7 years before seeing any cash flowing back).
Looking at the risk-return chart for various asset classes, it seems like investors are ‘forced’ to focus on equities and equities-like assets in order to achieve higher returns of more than 8%. Allocating closer to the lower left portion of the chart lowers the portfolio returns too much.
However, a key principle to the All-Weather portfolio is the fifth one: All asset classes have similar Sharpe ratios (return-to-risk ratio). In other words, assets that carry higher expected risks will have a corresponding higher expected return.
By using leverage (i.e., borrowing), Bridgewater Associates is able to increase an asset’s share of the total portfolio risk. Hence, by borrowing cash to buy more of one asset, risk share is increased. Conversely, reallocating money from the asset to cash lowers the asset’s risk share and unlevers (i.e., lowers debt) the portfolio.
Source: Bridgewater Associates
(x-axis = Expected return, y-axis = Volatility)
As an example, let’s consider the S&P 500 index and the US 10-year bond. In Bridgewater’s study, the expected return on the US 10-year treasury is ~7% while the return on the S&P 500 sits at ~8% with cash returning slightly more than 4%.
Accordingly, the excess return (above cash) on the S&P 500 and the US 10-year note are 3.4% and 2.7% respectively.
Source: Bridgewater Associates
Using a 2:1 leverage, investors can scale up the excess return on the US 10-year bond from 2.7% to 5.0% while keeping volatility just below the volatility of the S&P 500 (i.e., 14.8% vs. 15.6%).
Expanding on this idea, we can repackage all asset classes using leverage (i.e., levered or unlevered) to the same risk level as the S&P 500.
Source: Bridgewater Associates
Accordingly, we see that the opportunity set expands beyond US equities (or S&P 500), with no significant differences between the excess returns of equities and other asset classes. This allows investors to choose from a larger range of asset classes, allowing greater diversification.
The biggest difference this makes is that diversification is now achieved by combining things that are lowly correlated (different asset classes, e.g., stocks vs. bonds), as opposed to combining things that are highly correlated (variants of the same asset class like equities).
This is instrumental in creating a more consistent portfolio, i.e., higher return per unit risk.
Assembling a portfolio that balances risk evenly across all risk-equalized asset classes produces a Sharpe ratio superior to the conventional portfolio.
Source: Bridgewater Associates
Constructing the All-Weather Portfolio – Portfolio Allocation
Traditionally, finance theory recommends allocating to assets by optimizing the cross-asset correlation. In simple terms, it means finding the portfolio that returns the lowest amount of volatility (a measure of risk) for a given target return.
However, Bridgewater realised that correlations between assets are extremely unstable in and of itself. For example, the correlation between stocks and nominal bonds have fluctuated significantly over a 20-year period lasting from 1990 to 2010 (see chart below). These make optimizing portfolio based on correlations extremely sensitive to the inputs.
Source: Bridgewater Associates
To circumvent this, Bridgewater allocates risk based on the timeless understanding of the relationship between asset class performance and changes to the macroeconomic environments.
Fundamentally, asset prices represent expectations of future conditions and asset returns are driven by how conditions evolve relative to expectations. Asset class returns are largely the result of whether growth and inflation end up being higher or lower than expected, and how these expectations change.
By balancing risk evenly to rising and falling inflation or growth, a portfolio can be designed to withstand negative surprises to different environment changes.
Source: Bridgewater Associates
The underperformance of a given asset class (e.g., nominal bonds) in a given environment (e.g., high inflation) is naturally offset by the outperformance of another asset class (e.g., commodities). The portfolio consistently earns asset class risk premiums (excess return for the risk taken in various non-risk-free assets) while minimizing the susceptibility to deep drawdowns in any one environment.
Bridgewater also deploys diversification within each asset class, with each asset class being globally diversified. Consequently, the risk share shifts in the All-Weather portfolio as seen below:
Source: Bridgewater Associates
Results of the All-Weather Portfolio
The result of the All-Weather portfolio is a marked increase in Sharpe ratio (~0.67) over the conventional portfolio, which has a Sharpe ratio of 0.35.
When Bridgewater backtested this strategy from 1970 to 1996, the All-Weather portfolio delivered a much more consistent return at a lower risk level than a conventional portfolio. It also experienced a lower frequency and magnitude of drawdowns as compared to the conventional portfolio (see line charts below).
Source: Bridgewater Associates
Hence, if an investor is willing to accept the same risk level of a conventional portfolio, he/she can earn a much higher return consistently by deploying the All-Weather strategy.
By applying leverage to the All-Weather portfolio, an investor can increase the expected risk and, correspondingly, expected return of the All-Weather portfolio. In the chart below, when we raise the standard deviation (risk) of the portfolio via leverage, the All-Weather portfolio more consistently outperforms the conventional portfolio, with less frequent large drawdowns of smaller magnitude.
Source: Bridgewater Associates
Variants of the Quadrant Investment Framework
In truth, the All-Weather portfolio strategy is practically difficult for retail investors to implement. The use of leverage and the inclusion of a multitude of asset classes makes it administratively difficult of retail investors to manage (let alone getting access to these instruments).
While several online articles talk about how one can replicate the All-Weather portfolio using ETFs, the underlying assets are typically still equity in nature and highly correlated, bearing more similarities to the conventional portfolio than the All-Weather portfolio.
That said, Ray Dalio and his associates have provided us with an important framework to help us better understand the ebbs and flows of the financial market. While it is hard to say who first created the quadrant investment framework, it is most definitely a useful framework for any investor when thinking about cyclical allocations.
Note that when I say “cyclical”, it means a mid-term shift in one’s portfolio. In general, there are three main time frames to investing:
- Secular = a long-term timeframe of 10+ years driven by debt cycles, demographics, technology, long-term policy, globalization (or increasingly nearshoring / friendshoring)
- Cyclical = a mid-term timeframe driven by the ebbs and flows of business cycles, liquidity, and government and central bank policies; typically a few weeks to a few years long
- Tactical = a short-term timeframe driven by news, economic releases, earnings, sentiment, momentum and volatility; typically a day to a few weeks long
Several other similar quadrant frameworks also exist, echoing similar thoughts around asset allocation. First of which is Gavekal’s Four Quadrants Framework:
Source: Bloomberg
Similar to Bridgewater Associate, this framework also considers ‘growth’ and ‘inflation’ to be the key drivers. The key difference is that they are not viewed to be mutually exclusive (i.e., you can have an environment of rising inflation and rising growth, as opposed to having just one or the other).
A more detailed one with a slight tweak is Alfonso Picattielo’s framework. In place of inflation and growth, Alfonso views ‘Global Credit Impulse’ and ‘Relative Monetary Stance’ as the key drivers instead.
Source: The Macro Compass
Overlaying these frameworks gives us an important insight – ‘growth’ and ‘inflation’ should be viewed together with the policy regimes that we are in. In other words, rather than simply observing where the market expects ‘growth’ and ‘inflation’ to be, we also need to consider how the policy makers (like the central banks) are acting.
When viewed from a cyclical allocation perspective, an investor can shift / tilt the weight of his/her investments in certain assets if he/she believes that the market expectation is likely to shift to a different quadrant.
These frameworks help investors to understand where capital flows are happening as macroeconomic environment shifts.
Contact
- e: info@thehatchfund.com