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Bridgewater Associates: Not Too Much Edge in Levered Betas - December 2008
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Bridgewater Associates: Not Too Much Edge in Levered Betas - December 2008


Bridgewater Associates: Collection of Writings (1999-2012)

Bridgewater Associates: Collection of Writings (1999-2012)

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  • 1. Bridgewater® Daily Observations December 26, 2008 © 2008 Bridgewater Associates, Inc. (203) 226-3030 Bob Prince Noah Yechiely Kerry Reilly United States Not Much Edge in Levered Betas: Three days to the end of the year and the hedge fund industry is nervously waiting for the ball to drop on 2008. Not many of the existing managers were at the legal investment age to remember 1998, but 2008 closes a circle on a new generation of levered beta managers. In contrast to 1998, we believe the scars in the collective investors’ memory are much deeper and broader. The hedge fund index is at the same level as at the end of 2005. Hedge funds did not deliver the promised hedge (only one sizeable style was positive as of the end of November), blue-chip funds raised gates, and some funds delivered made up alpha. We have no doubt the rules need to be re-written. In particular, increased transparency on the source of returns. A noteworthy observation comparing 2008 and 1998 is that hedge funds produced positive gross alpha (2.3% and 5.2%, respectively), albeit took most of it as fees. The reason being hedge funds had enough time to de-lever (by about 50% since end of 2006) and moved to cash, or they gated their funds to avoid their assets’ fire sales. Many funds will close their doors, as their economics do not work anymore given their high watermark levels, but a very low number have actually blown up. As you know, we generally view the move into hedge funds as part of the evolution of money management. As we have described for many years now, the investment world should – and will – evolve towards a world of separating passive investment decisions (we call them beta) from active investment decisions (alpha). Most institutional investors continue to tie together their alpha and beta decisions (i.e. an institution typically decides how much money they want in equities and then goes out and hires equity managers to manage it). This is clearly inefficient, as the two decisions need not be linked and linking them precludes improved risk allocation. Instead, investors should decide which asset classes they want to be in and then overlay on top of those asset classes the best alpha managers they can find, no matter which asset class they get their alpha from. This is alpha overlay and it is a better way to run a portfolio. Cutting-edge institutions have begun to manage their assets this way, and the rest of the world will eventually adopt this superior strategy. Too often, however, hedge funds are mixing alpha and beta together, blurring the picture. To be clear, there are only two ways to make money in the market, and it is essential to be able to differentiate between them. The general perception was that hedge funds are providing alpha. The truth came out in 2008: many hedge funds were packaging up beta and selling it at alpha prices. When we strip many hedge fund “strategies” from the beta that underlies them, we find that quite often they are not wearing any clothes at all. We have noted this several times in the past couple of years. In January 2007 we wrote, “…Returns for hedge funds were decent in 2006. The CSFB/Tremont index of hedge funds showed returns of 13.6% through November. Hedge funds continued to raise assets, albeit at a slowing rate, our estimates indicate the increase in hedge funds’ AuM topped $150 billion for the year. To get these returns, in the current low volatility environment, hedge funds have levered up, increasing Bridgewater ® Daily Observations is protected by copyright. No part of the Bridgewater ® Daily Observations may be duplicated or redistributed without prior consent from Bridgewater Associates. Copying or redistribution of The Bridgewater ® Daily Observations is in violation of the US Federal copyright law (T 17, US code). 1 Bridgewater ® Daily Observations 12/26/2008
  • 2. leverage ratios by over 70% by our calculations, in the last 3 years. Hedge funds in aggregate have reached leverage levels not seen since 1998, when LTCM dominated, and assets were tiny. …..Both assets under management and leverage ratios continue to surge…. It is clear that many hedge funds have a significant beta component, and with so much levered money chasing a limited number of illiquid betas, it is not surprising that risk premiums have collapsed. Some of this risk premium compression was reasonable, but now it seems pretty indiscriminate. While a lot more than hedge funds have caused risk spreads to be so tight, the increasingly leveraged money in hedge funds means that a stumble in the spread area could easily turn into a stampede. We are extremely wary of these betas.” And in November 2007, “…Since January, hedge funds have been tested several times, but they have definitely not been stress tested. The August tremor unearthed some cracks: large exposure to illiquid betas and crowded up strategies in tandem with a wave of de-levering from peak leverage ratios (since the 1998 LTCM debacle) caused a cascade across all systematic biases. The tremor has not turned into a full-scale quake due to the ample global liquidity continuing to pour into financial assets. Money flows into hedge funds were positive in the third quarter, albeit at a slowing pace. Flows in 2007 through September are accelerating at an annual rate of 300 $US blns (40% above the 2006 rate) and shifting from distressed debt to the next risky flavor of the day; emerging market equities (which now make up more than 60% of flows. . . In 2007, hedge funds performed well because they tend to hold risky assets relative to safe ones. Risky assets have been supported by a flood of liquidity, enough of which has poured into alternatives. The low volatility would have been a problem except for the levering up by hedge funds. The problem on a forward looking basis is that there is very little left to squeeze out of risky assets. Bridgewater’s aggregate risk spreads show the tightest level in forty years. The high beta content of hedge fund returns make us suspect that the universe will not fare well in a reversal of liquidity. November, so far, has been a tough month for hedge funds, but this is nothing relative to a real withdrawal of liquidity. We doubt that this is imminent, but it is a possibility and eventually we will see the other side of the liquidity cycle. . .” In 2008, hedge funds lost 20% relative to cash compared to the 60/40 portfolio, which was down 17.5%. This has been the worst year since 1994. Moreover, the distribution of and magnitude of losses eclipses 1998 when most of the losses were concentrated in emerging market funds. This year, emerging market (the strategy that attracted the majority of inventors’ new allocations) performed indistinguishably bad. Hedge Funds Excess Return 2008 -50% -40% -30% -20% -10% 0% 10% 20% Dedicated M anaged Global 60/40 Event Total Equity L/S FI Arb Emerging Converts Equity Short Futures M acro Portfolio Driven Hedge M arkets M arket Funds Neutral 2 Bridgewater ® Daily Observations 12/26/2008
  • 3. Hedge Funds Excess Return 1998 20% 10% 0% -10% -20% -30% -40% -50% Dedicated M anaged Global 60/40 Event Total Equity L/S FI Arb Emerging Converts Equity Short Futures M acro Portfolio Driven Hedge M arkets M arket Funds Neutral The next chart shows hedge fund risk allocation. The degree of systematic exposure to the equity market is still extremely high followed by trend followers (CTAs). The latter became popular in the last three years as it produced positive returns consistently. These returns are a product of trending markets, a likely by-product of the levering and de-levering process that occurred in the past three years. 0% 5% 10% 15% 20% 25% 30% 35% 40% Dec-2008 Dec-2007 Equities Market Corporate EMD Equities Yields MBS Short Vol. Dev. Trend HY Em. As holders of systematic risks and illiquid assets, hedge funds are at the mercy of expanding risk premia and falling market liquidity. The correlation of liquidity and risk premia is material and turned high in 2008 when risk premia expanded sharply and markets turned illiquid. This turn of events is catastrophic for hedge funds, in particularly, highly leveraged hedge funds in dire need for liquidity to meet margin calls. The next charts show the Z-score of the risk premia and Bridgewater’s market liquidity gauge. Risk Premia (Z-score) BW Liquidity Gauge (Z-score) 8 6 4 2 0 -2 -4 3 Bridgewater ® Daily Observations 12/26/2008 Illiquid Markets/High Risk Premia Liquid Markets/Low Risk Premia 60 64 68 72 76 80 84 88 92 96 00 04 08
  • 4. Hedge fund betas (systemic risks and liquidity premiums), in many cases, are not hard to strip out. For instance: Emerging Market: Emerging market hedge funds have been the most popular of late despite lagging an emerging market beta portfolio that could be put together with ETFs. Emerging market hedge funds are over 80% correlated to a simple 50/50 mix of emerging market equities and bonds and are failing to outperform this basic combo. Fixed Income Arbitrage: One of the most popular hedge fund strategies has been fixed income arbitrage. This is a classic beta strategy. We don’t claim to be experts at what all of these guys are doing, but in aggregate, the picture is pretty clear. Simplistically, these funds are taking three systematic risks. The primary systematic risk is buying illiquid, risky securities (e.g. MBS, EMD) and shorting more liquid, less risky securities. The second strategy is positive carry trades (e.g. long-term US treasuries vs. cash). The third strategy is selling volatility. Some funds can probably sort the good securities from the bad ones, but in aggregate, fixed income arb funds have simply returned the beta of buying illiquid fixed income instruments. In aggregate, they are highly correlated to the naïve strategy of being long a simple combo of mortgages, emerging market debt, euro dollars relative to treasuries, long- vs. short-term treasuries, high yielding currencies, and short volatility. All of these betas are now highly squeezed. Convertible Arbitrage: Convert arb has been a popular hedge fund strategy for years, but the strategy has a large beta component to it. Convertible arbitrage funds take convertible bonds and hedge out some of the underlying pieces. A convertible bond has three components (credit, volatility, and equity). Most convertible arb players are going to do well when convertible bonds are sold at a discount to the underlying pieces, and poorly when the convertible bonds sell at a premium. That is why most convertible arb funds are so highly correlated. For much of the last decade there has been more supply of converts than demand, which has allowed converts to trade at a discount. In 2008, the situation flipped, not that convertibles became more expensive, to the contrary they became even cheaper. Hedge funds sold at any price to increase liquidity and meet redemptions. But, when hedge funds hold roughly 70% of the total convertible market, we saw a situation of many sellers, and very few buyers. Distressed: Distressed securities hedge funds match up well to a basic mix of junk bonds and high- yielding emerging market debt. You get the point. We have discussed our hedge fund returns replication process, which closely tracks hedge fund return indices, before, so we won’t bore you with the details; suffice to say our estimate of the betas in hedge funds are 90% correlated to the aggregate hedge fund index. Hedge Fund Index Returns (Excess of Cash, Net of Fees) - Rolling 6mo BW's Replication Portfolio - Rolling 6mo 25% 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% Correlation: 0.9 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 4 Bridgewater ® Daily Observations 12/26/2008
  • 5. The following table shows many of our individual hedge fund strategy replications. Convertible Arbitrage Emerging Markets Index Replication Index Replication 30% Correlation: 0.7 50% 40% 20% 30% 10% 20% 10%0% 0% -10% -10% -20% -20% -30% -30% -40% -40% -50% 93 95 97 99 01 03 05 07 09 93 95 97 99 01 03 05 07 09 Correlation:0.83 Event Driven Fixed Income Arbitrage Distressed Debt Act. Replication Index Replication 20% 15% Correlation: 0.87 10%15% 5% 10% 0% 5% -5% 0% -10% -5% -15% -10% -20% -15% -25% -20% -30% 93 95 97 99 01 03 05 07 09 93 95 97 99 01 03 05 07 09 Correlation: 0.78 Global Macro Long/Short Equity Index Replication Index Replication 50% Correlation: 0.81 50% 40% 40% 30% 30% 20% 20% 10% 10% 0% 0% -10% -10%-20% -30% -20% -40% -30% 93 95 97 99 01 03 05 07 09 93 95 97 99 01 03 05 07 09 Correlation: 0.82 5 Bridgewater ® Daily Observations 12/26/2008
  • 6. Theoretically, if hedge fund betas are replicable then the actual alpha captured by hedge funds is the difference between the actual returns and the replication. The next chart shows the annual gross alpha hedge fund returned, where at each year they charges roughly 50% of the average gross alpha (~4%) in management fees (~2%). Hedge Funds Gross Alpha -6% -4% -2% 0% 2% 4% 6% 8% 10% 12% 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 The next chart shows the alpha as % of total market cap of securities traded globally (~$100 Tr in 2008). The average alpha is pretty consistent over the years and equal to 5bps! or 50blns in 2008. Since the alpha is pretty consistent it is spread thinly across the hedge funds industry, which quadrupled in AuM between 2002 and 2008. Alpha As % of Total Market Cap of Traded Securities[bps] 35 30 25 20 15 10 5 0 -5 -10 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 The next chart shows, for comparison, the cumulative excess return (beta + alpha) and the cumulative alpha return. It is easy to observe the overweighing of beta in hedge funds’ returns. Hedge Funds Cumulative Excess Returns (ln) Hedge Funds Cumulative Alpha Returns 100% 80% 60% 40% 20% 0% -20% 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 6 Bridgewater ® Daily Observations 12/26/2008
  • 7. The confluence of negative returns, illiquid holdings, and unprecedented investors’ redemptions led to massive delivering of >50% and a sell off of about $1.5 Tr of assets. As the next charts illustrates, hedge funds are currently running at a very low to no leverage. Much of the liquid assets were sold to meet investors’ redemptions. -500 500 1500 2500 3500 4500 Assets [$US blns] Holdings (Levered Assets 6mma) Holdings (Unsmoothed Leverage) In 2008, Hedge funds sold more than $1.5 Tr of holdings 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 The next chart shows our estimate of future redemptions. We expect those to increase in size ($600 blns annual rate), in turn leading to further liquidation of assets. If redemptions continue, hedge funds will find it hard to escape liquidating their less liquid holdings. This will likely come at a time when banks (holding similar illiquid assets) are, with the help of the government, dumping massive amounts of these assets in order to re-capitalize and clean balance sheets. Investors’ Inflows/Withdrawals into Hedge Funds [$US blns Ann’d] -1000 -800 -600 -400 -200 0 200 400 600 1m ; Ann's 3mma ; Ann'd Estimate 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 The great thing about this is that the recent environment has provided a severe stress test of hedge fund strategies. Previously, opaque biases to earn risk premiums (buy the dips, a play for mean reversion, etc) have been revealed. Given this X-ray, it is a much better time to allocate funds to hedge funds than ever. The reality is that alpha is rare, but attainable. There were a few good ones before and a few good ones now. It is now a lot easier to see who they are who they are not, and moderately easier to see who they might be. 7 Bridgewater ® Daily Observations 12/26/2008
  • 8. Other Industrialized Countries Collapsing Global Trade Global trade is collapsing. In part, this reflects the global economic slowdown and the drop in commodity prices. On the margin this is negative for export-dependent economies who have built up a lot of capacity to satisfy a level of global demand that was the product of ever-increasing leverage (e.g., China, Japan). The resulting excess capacity is also a powerful deflationary force globally. For the countries that have reported exports for November (representing just over 25% of world exports of $14 trillion), the numbers have been extremely weak. While the table below shows the picture in dollars to make relative size comparison easier, the size of the drop is similar in local currency. Exports of Countries That Have Reported For November Annlzd. Exports (USD, bn) Annlzd. Exports Y/Y (USD, bn) Sep-08 Oct-08 Nov-08 Sep-08 Oct-08 Nov-08 China 1,532 1,521 1,286 21.6% 19.3% -2.1% Japan 795 804 697 9.6% 7.1% -11.4% Korea 450 435 327 27.6% 8.5% -19.0% Singapore 350 304 269 15.1% -6.7% -15.8% Taiwan 241 224 187 -1.9% -8.3% -24.1% Brazil 230 211 176 41.5% 17.6% 5.2% Switzerland 198 187 158 14.5% 0.1% -15.9% Norway 161 131 122 6.3% -14.8% -22.6% Chile 59 68 56 -9.8% -11.9% -19.0% Total 4,003 3,863 3,277 16.5% 7.9% -10.2% This drop has been quite broad based. The charts below show the level and change of trade for the five largest countries above. -200 300 800 1,300 1,800 1/1/81 1/1/90 1/1/99 1/1/08 China Imports ($bn) China Exports ($bn) -60% -40% -20% 0% 20% 40% 60% 80% 100% 1/1/81 1/1/90 1/1/99 1/1/08 China Imports (US$, Y/Y) China Exports (US$, Y/Y) 8 Bridgewater ® Daily Observations 12/26/2008
  • 9. Japan Imports ($bn) Japan Exports ($bn) 900 700 500 300 100 -100 1/1/70 1/1/82 1/1/94 1/1/06 Korea Imports ($bn) Korea Exports ($bn) 600 500 400 300 200 100 0 -100 1/1/70 1/1/81 1/1/92 1/1/03 Singapore Imports ($bn) Singapore Exports ($bn) Japan Imports (US$, Y/Y) Japan Exports (US$, Y/Y) -40% -20% 0% 20% 40% 60% 80% 100% 120% 1/1/70 1/1/82 1/1/94 1/1/06 -100% -50% 0% 50% 100% 150% 200% 1/1/70 1/1/82 1/1/94 1/1/06 Korea Imports (US$, Y/Y) Korea Exports (US$, Y/Y) Singapore Imports (US$, Y/Y) Singapore Exports (US$, Y/Y) 450 350 250 150 50 -50 140% 120% 100% 80% 60% 40% 20% 0% -20% -40% 1/1/70 1/1/81 1/1/92 1/1/03 1/1/70 1/1/82 1/1/94 1/1/06 Taiw an Imports ($bn) Taiw an Exports ($bn) Taiw an Imports (US$, Y/Y) Taiw an Exports (US$, Y/Y) 350 300 250 200 150 100 50 0 -50 120% 100% 80% 60% 40% 20% 0% -20% -40% -60% 1/1/70 1/1/81 1/1/92 1/1/03 1/1/70 1/1/82 1/1/94 1/1/06 9 Bridgewater ® Daily Observations 12/26/2008
  • 10. All of the numbers we have shown above are nominal (most countries release their “real” export measures with an extra month lag). This raises a question since the drop in commodity prices has been significant, and the prices could be causing the drop (rather than volumes, which would tie to real growth). Japan is the exception, with an export price index through November (and they are not much of a commodity exporter anyway). The drop looks nearly as big in real terms. Japan Real Export Index Japan Real Exports Y/Y 1/1/70 1/1/81 1/1/92 1/1/03 1/1/70 1/1/82 1/1/94 1/1/06 If this magnitude of drop carries over to the other countries, this will be a significant drop in the secular uptrend of global trade. 0 10 20 30 40 50 60 70 80 -20% -10% 0% 10% 20% 30% 40% 50% World Trade (World Imports/Exports, % GDP) Estimate Based on Countries that Have Reported for November 8% 13% 18% 23% 28% 1/1/70 1/1/74 1/1/78 1/1/82 1/1/86 1/1/90 1/1/94 1/1/98 1/1/02 1/1/06 This would be by far the largest year-over-year drop since 1970. Y-Y Change in Gross World Trade % GDP Estimate Based on Countries That Have Reported for November -8% -6% -4% -2% 0% 2% 4% 1/1/71 1/1/75 1/1/79 1/1/83 1/1/87 1/1/91 1/1/95 1/1/99 1/1/03 1/1/07 10 Bridgewater ® Daily Observations 12/26/2008
  • 11. Global trade tends to be quite correlated to global real GDP growth, which we currently estimate to be close to zero (including developed and emerging countries) and is slowing rapidly. Y-Y Change in Gross World Trade % GDP (dotted line = Nov. Estimate) World Coincident Grow th Y/Y 5% 3% 1% -1% -3% -5% -7% 8% 6% 4% 2% 0% -2% -4% 1/1/70 1/1/74 1/1/78 1/1/82 1/1/86 1/1/90 1/1/94 1/1/98 1/1/02 1/1/06 Trade (in nominal terms) is also correlated to commodity prices, since commodities make up a significant chunk of trade. Y-Y Change in Gross World Trade % GDP(dotted line = Nov. Estimate) Cmd Prices Y/Y (ln) 4% 2% 0% -2% -4% -6% -8% 1/1/70 1/1/74 1/1/78 1/1/82 1/1/86 1/1/90 1/1/94 1/1/98 1/1/02 1/1/06 60% 40% 20% 0% -20% -40% -60% -80% -100% -120% The chart below shows a comparison of the numbers for November with a quick combination of world growth and commodity prices, it looks like the drop in exports has been larger than the weakness in these two factors would suggest. Of course, this is imprecise and only 25% of countries have reported trade figures for November. The difference could be partly explained by the credit crunch hitting trade finance (as the Wall Street Journal called it, “the oil that lubricates global trade”), which has anecdotally been mentioned in the press. There have also been reports of increasing protectionism (Russia raising auto tariffs, India raising steel duties, etc.) which may be beginning to have some minor impact. 11 Bridgewater ® Daily Observations 12/26/2008
  • 12. Y-Y Change in Gross World Trade % GDP (dotted line = Nov. Estimate) Estimate Based on World Grow th, Cmd Prices -8% -6% -4% -2% 0% 2% 4% Trade dropping faster than even grow th, commodity price w ould suggest 1/1/70 1/1/74 1/1/78 1/1/82 1/1/86 1/1/90 1/1/94 1/1/98 1/1/02 1/1/06 This drop in trade has been mirrored by a collapse in the Baltic freight index. The index has stabilized in December, though shows no signs of a rebound. 0 2,000 4,000 6,000 8,000 10,000 12,000 Baltic Dry Freight Index Low est since 1986 1/1/85 1/1/88 1/1/91 1/1/94 1/1/97 1/1/00 1/1/03 1/1/06 1/1/09 This collapse in trade will force export-dependent economies who have built up a lot of capacity to adjust to the new level of global demand. We are already seeing this in China, where demand is shifting from export-oriented production to domestic consumption (seen in the continued strong retail sales numbers). Given this rapid deterioration in export prospects, this shift will have to happen quickly to avoid a hard landing. It will also be a deflationary force globally which governments and central bankers will have to offset to avoid a deflationary debt spiral. 12 Bridgewater ® Daily Observations 12/26/2008
  • 13. Conclusions Credit Markets N. America US US Canadian Bonds Euro$ Short rates Strongly Bullish Strongly Bullish Strongly Bullish Europe UK Gilts Euroland Bonds UK Euro£ Euroland Short rates Strongly Bullish Strongly Bullish Strongly Bullish Strongly Bullish Asia Japanese Australian Japanese Australian Bonds Bonds Euro¥ Bank Bills Strongly Bullish Moderately Bearish Strongly Bullish Strongly Bullish Currency Markets CAD v USD EUR v USD GBP v USD JPY v USD AUD v USD Moderately Bullish Neutral Neutral Strongly Bullish Neutral Equity Markets US Equities Japanese Equities German Equities UK Equities French Equities Canadian Equities Australian Equities Neutral Neutral Neutral Neutral Neutral Neutral Neutral Note: Bridgewater Daily Observations is prepared by and is the property of Bridgewater Associates, Inc. and is circulated for informational and educational purposes only. There is no consideration given to the specific investment needs, objectives or tolerances of any of the recipients. Additionally, Bridgewater's actual investment positions may, and often will, vary from its conclusions discussed herein based on any number of factors, such as client investment restrictions, portfolio rebalancing and transactions costs, among others. Recipients should consult their own advisors, including tax advisors, before making any investment decision. This report is not an offer to sell or the solicitation of an offer to buy the securities or other instruments mentioned. Bridgewater research is based primarily upon proprietary analysis of current public information from sources that Bridgewater considers reliable, but it does not assume responsibility for the accuracy of the data. The views expressed herein are solely those of Bridgewater as of the date of this report and are subject to change without notice. The views represent Bridgewater's outright views in these specific markets, but not all markets that Bridgewater trades. Bridgewater may have a significant financial interest in one or more of the positions and/or securities or derivatives discussed. Those responsible for preparing this report receive compensation based upon various factors, including, among other things, the quality of their work and firm revenues. 13 Bridgewater ® Daily Observations 12/26/2008