ALPHA vs. BETA (Round 3)

Passively-managed vehicles such as exchange-traded funds are increasingly featuring in investors’ portfolios, but there is a danger clients may be lulled into a false sense of security and strong asset allocation is still important for delivering returns, according to a white paper from Momentum Global Investment Management.

 

The report, issued in conjunction with the Scorpio Partnership consultancy, said that in the last three years, more than half of wealth advisors had introduced a passive investment approach in clients’ portfolios.

The debate on whether “active” or “passive” investment management is best is a constant theme in wealth management. With active management, where people pay a higher fee to a manager in return for acquiring market-beating returns, it is argued this approach is less effective in large, efficient markets where mispricing is harder to sustain; passive management is a lower-cost approach.  

The issue of what is the most cost-efficient way for investors to express their views in a market comes at a time when the issue of costs and fees is rising up the agenda. The UK reform program to financial advice – the Retail Distribution Review – is forcing managers to be more transparent on their fees and encouraging some advisors to farm out discretionary wealth management. The issues are complex – there is no “right” or “wrong” answer to what is the most suitable way to invest, the report said. “Whether to go active or passive is just one decision when managing a portfolio. This decision is an output of a much larger decision tree, and for us is very context-dependent,” the report said. “Essentially, the active versus passive debate for us is partly an implementation question. We aim to find the most efficient way to get the exposure that we want. At times the most efficient way might be to use passive strategies, while in others the best route may be active management,” it said.

On asset allocation, the report argued that “going passive” requires investors to get asset allocation policy correct.

“A passive solution may not save you from market crashes. Whether you are in an active equity fund or a passive equity fund, if markets fall by 20 per cent you are likely to suffer material and painful losses,” it said.

The report also argues that while passive investing is generally less expensive than active investing, this is not always the case. In the credit markets, such as in high yield and loans, passive can often be more costly. The costs of an active portfolio in loans ranges from 40 to 100 basis points, compared with an average of 83 per cent for passive funds.

With passive funds, cost issues can arise depending on the nature of an index that a passive vehicle tracks. For example, the report said that hedge funds arbitraging the rebalancing and membership of an index such as the FTSE index comes at the expense of performance of passive strategies. A strict tracker fund must buy stocks after they have appreciated and sell others after they have fallen.

By WealthBriefing, MGIM White Paper

Additional Resources FundQuest White Paper (When Active Management Shines vs. Passive – June 2010)

See Post September 29, 2011: ALPHA vs. BETA (Round 2)

See Post April 1, 2010: Consistent Alpha

Lessons for Wealth Management

Wealth management profitability is being squeezed on a number of fronts and the industry faces some of the pressures hitting the mass market for overseeing client money, according to Deloitte. Risk-shy investors, rising regulatory costs and growing demand for low-margin, passive fund vehicles has the asset management sector in a vice, requiring big changes on how firms do business to survive, Deloitte says. On current trends, fees will be under downward pressure, it says. And these points also apply to wealth management, Deloitte argues.

While there are clear differences between the financial dynamics of wealth and asset management, Deloitte said its comments, issued a few days ago, to an extent apply not just to the mass market in funds, but also to firms serving high and ultra high net worth individuals.

“I have always found it interesting that this [fund management] service is a market in some ways that is retail, and yet a shopkeeper can understand the profit he or she makes, say, on every tin of beans on the shelf that gets sold, but wealth and asset managers may have far less idea of the profit they make in their market,” Eliza Dungworth, lead investment manager partner at Deloitte, told this publication.

A number of firms have already squeezed their fees; more may do so, Deloitte citing the example of Schroders, which is launching a Z share class for its UK-domiciled funds, carrying a management charge but no fees for platforms or advisor rebates. Another example is Vinculum, a new UK investment house started last year that charges no management fees at all.

Deloitte predicts that the big regulatory development sweeping the UK market – the Retail Distribution Review – will, on its own, drive down fees. It will reduce the management fee paid to investment managers by between 50 to 75 basis points. (The RDR is designed to stamp out sales commissions and raise the quality of professional advice, which is seen as driving up barriers to entry into the advisory market). Other regulatory forces include the European Union’s Alternative Investment Fund Managers Directive and legislation such as FATCA, the US measure to crack down on cross-border tax evasion. 

Lipper, the fund research company, made a similar point last year: “Today the RDR looms large over the industry and the change expected to impact on the way intermediaries are remunerated being one of the key elements on which the initiative is based. The proposed changes to the way funds are distributed are such that the previously glacial pace at which apparent price wars had been fought over the previous twelve years has begun to quicken, with US low-cost giant Vanguard – 10 years after it entered the European industry – setting up UK-domiciled funds in 2009.”

But while the overall impression is one of tight, or tighter, margins, precise data for the industry as a whole can be hard to find, especially in wealth management. A lack of clear data on how much profit is made on specific service offerings is only one aspect of a problem in wealth management. Information about fees and what rival firms charge for specific services is often unobtainable.

Profits under pressure

The urgency of the profitability problem was underscored by a number of industry reports last year. PricewaterhouseCoopers’ biannual report on global wealth management found that the average cost-to-income ratio is 71 per cent: only 28 per cent of respondents reported cost-to-income ratios of less than 60 per cent, while only nine per cent also achieved revenue growth in excess of 10 per cent.

Scorpio Partnership, in its 2011 survey, had a higher average cost/income ratio figure of almost 80 per cent, a record figure, it said. (Some differences in the type of answers to questions may explain some of the cost-income ratio differences between the PwC and Scorpio figures.)

In some parts of the world, such as Switzerland, the older, lower cost/income ratio business of handling secret bank accounts and doing relatively little work for it is being edged out by a more expensive, labour-intensive model as Swiss bank secrecy comes under international assault.

With asset management, cost/income ratios, or, to put it another way, margins, can on average be lower than for some wealth management offerings, depending on whether the funds carry high fees (as in the cast of hedge funds with their classic “2 and 20” management and performance fee structures), or very low ones, as in exchange-traded funds. Each end of the market – those seeking “Alpha” or capturing market “Beta” – resemble what Morgan Stanley analyst Huw van Steenis has dubbed the asset management “barbell” . One end of the barbell is a low-margin business, the other is a higher-margin one.

By WealthBriefing (modified by Louay Al-Doory)

Seasonal Greetings & Happy New Year

 

Letter from Dubai

The pulsating economic jewel of the Middle East is beginning to look a little tarnished. Unshakable during the Arab Spring, Dubai has never been shy about publicising its glitzy attractions, which mostly come down to a property-owning paradise for the wealthy and aspirational.

And yet is trouble brewing within the most senior ranks of the establishment? The United Arab Emirates security forces became quite exercised last month when no less an organisation than the International Bar Association – the legal industry body – reportedly came under scrutiny amid fears that some items on their agenda could serve as fuel for those unhappy with the more restrictive aspects of Middle Eastern life. Some agenda items, including discussions on human rights, the death penalty and migrant workers, were reported to have been hastily amended or dropped. This apparent paranoia about the possibility that the Arab Spring might spread to Dubai suggests that an uneasy status quo could yet be disrupted. So far, it has been easier to think of Dubai as a safe haven amid the chaos that engulfs much of the region.

Cash-rich millionaires from India, Pakistan and Russia are still buying properties in areas of Dubai such as Emirates Hills, where the gated communities and shrub-lined roads bear more than a passing resemblance to parts of Arizona or Palm Desert in the US.

But its aspiration as the financial centre of the Middle East is suffering setbacks.

Last month Dubai stocks reached a seven-year low, weighed down by the eurozone debt crisis and problems closer to home when its largest investment bank, Shuaa Capital, said it would cut jobs and scale back its brokerage business.

Goldman Sachs recently cut its 2011-13 earnings estimates of the Dubai Financial Market, the local stock exchange, by about 40 per cent, reflecting the weak volumes and a slow recovery in earnings of constituent stocks. Goldman also slashed its target stock price on the DFI, the only listed bourse in the Middle East, and reiterated its sell rating on the stock.

Before the global financial crisis struck, Dubai’s economy had been expanding. But by the end of 2009, it was forced to warn that its largest government-related entity, Dubai World, needed to freeze repayments on $26bn of debt, triggering fears of a sovereign default long before such a thing became widespread. Its gross domestic product contracted 2.4% that year.

But Dubai has recovered well. GDP was up 1.7% in 2010 and is projected to rise by more than 3% this year, according to the Institute of International Finance.

As a centre for banking, Dubai is still young. Just 40 years have passed since the UAE first introduced a currency. At that time, Lebanon was the financial hub of the Middle East, but when the civil war began in 1975 most banks fled to Bahrain.

For tourists, Dubai still delivers what is expected: ridiculously green golf courses surrounded by desert, an eight-lane highway nose to tail with the world’s most expensive cars, immaculately dressed people and implausibly tall buildings – even though some are only half finished. The shopping malls would still make Westfield Stratford shopping centre in East London look like a corner store.

But outward trappings of wealth and the influx of millionaires aside, Dubai and other gulf states could face significant challenges and are vulnerable to regional tensions. Dubai’s proximity to Iran is beginning to play larger in the minds of investors than the money that could once be made in the property market.

By Anuj Gangahar Financial News

Adventures of the Arabian Nights

U.S. troops are in the process of completing their withdrawl from Iraq by the end of the year. Iran has been preparing for the U.S. withdrawl. While it is unreasonable simply to say that Iran will dominate Iraq, it is fair to say Tehran will have tremendous influence in Baghdad to the point of being able to block Iraqi initiatives Iran opposes. This influence will increase as the U.S. withdrawal concludes and it becomes clear there will be no sudden reversal in the withdrawal policy.

 

The situation in Syria complicates all of this. The minority Alawite sect has dominated the Syrian government since 1970, when the current president’s father — who headed the Syrian air force — staged a coup. The Alawites are a heterodox Muslim sect related to a Shiite offshoot and make up about 7 percent of the country’s population, which is mostly Sunni. The new Alawite government was Nasserite in nature, meaning it was secular, socialist and built around the military. When Islam rose as a political force in the Arab world, the Syrians — alienated from the Sadat regime in Egypt — saw Iran as a bulwark. The Iranian Islamist regime gave the Syrian secular regime immunity against Shiite fundamentalists in Lebanon. The Iranians also gave Syria support in its external adventures in Lebanon, and more important, in its suppression of Syria’s Sunni majority.

Syria and Iran were particularly aligned in Lebanon. In the early 1980s, after the Khomeini revolution, the Iranians sought to increase their influence in the Islamic world by supporting radical Shiite forces. Hezbollah was one of these. Syria had invaded Lebanon in 1975 on behalf of the Christians and opposed the Palestine Liberation Organization, to give you a sense of the complexity. Syria regarded Lebanon as historically part of Syria, and sought to assert its influence over it. Via Iran, Hezbollah became an instrument of Syrian power in Lebanon.

Iran and Syria, therefore, entered a long-term if not altogether stable alliance that has lasted to this day. In the current unrest in Syria, the Saudis and Turks in addition to the Americans all have been hostile to the regime of President Bashar al Assad. Iran is the one country that on the whole has remained supportive of the current Syrian government.

There is good reason for this. Prior to the uprising, the precise relationship between Syria and Iran was variable. Syria was able to act autonomously in its dealings with Iran and Iran’s proxies in Lebanon. While an important backer of groups like Hezbollah, the al Assad regime in many ways checked Hezbollah’s power in Lebanon, with the Syrians playing the dominant role there. The Syrian uprising has put the al Assad regime on the defensive, however, making it more interested in a firm, stable relationship with Iran. Damascus finds itself isolated in the Sunni world, with Turkey and the Arab League against it. Iran — and intriguingly, Iraqi Prime Minister Nouri al-Maliki — have constituted al Assad’s exterior support.

Thus far al Assad has resisted his enemies. Though some mid- to low-ranking Sunnis have defected, his military remains largely intact; this is because the Alawites control key units. Events in Libya drove home to an embattled Syrian leadership — and even to some of its adversaries within the military — the consequences of losing. The military has held together, and an unarmed or poorly armed populace, no matter how large, cannot defeat an intact military force. The key for those who would see al Assad fall is to divide the military.

If al Assad survives — and at the moment, wishful thinking by outsiders aside, he is surviving — Iran will be the big winner. If Iraq falls under substantial Iranian influence and the al Assad regime — isolated from most countries but supported by Tehran — survives in Syria, then Iran could emerge with a sphere of influence stretching from western Afghanistan to the Mediterranean (the latter via Hezbollah). Achieving this would not require deploying Iranian conventional forces — al Assad’s survival alone would suffice. However, the prospect of a Syrian regime beholden to Iran would open up the possibility of the westward deployment of Iranian forces, and that possibility alone would have significant repercussions.

Consider the map were this sphere of influence to exist. The northern borders of Saudi Arabia and Jordan would touch this sphere, as would Turkey’s southern border. It remains unclear, of course, just how well Iran could manage this sphere, e.g., what type of force it could project into it. Maps alone will not provide an understanding of the problem. But they do point to the problem. And the problem is the potential — not certain — creation of a block under Iranian influence that would cut through a huge swath of strategic territory.

It should be remembered that in addition to Iran’s covert network of militant proxies, Iran’s conventional forces are substantial. While they could not confront U.S. armored divisions and survive, there are no U.S. armoured divisions on the ground between Iran and Lebanon. Iran’s ability to bring sufficient force to bear in such a sphere increases the risks to the Saudis in particular. Iran’s goal is to increase the risk such that Saudi Arabia would calculate that accommodation is more prudent than resistance. Changing the map can help achieve this.

It follows that those frightened by this prospect — the United States, Israel, Saudi Arabia and Turkey — would seek to stymie it. At present, the place to block it no longer is Iraq, where Iran already has the upper hand. Instead, it is Syria. And the key move in Syria is to do everything possible to bring about al Assad’s overthrow.

In the last week, the Syrian unrest appeared to take on a new dimension. Until recently, the most significant opposition activity appeared to be outside of Syria, with much of the resistance reported in the media coming from externally based opposition groups. The degree of effective opposition was never clear. Certainly, the Sunni majority opposes and hates the al Assad regime. But opposition and emotion do not bring down a regime consisting of men fighting for their lives. And it wasn’t clear that the resistance was as strong as the outside propaganda claimed.

Last week, however, the Free Syrian Army — a group of Sunni defectors operating out of Turkey and Lebanon — claimed defectors carried out organized attacks on government facilities, ranging from an air force intelligence facility (a particularly sensitive point given the history of the regime) to Baath Party buildings in the greater Damascus area. These were not the first attacks claimed by the FSA, but they were heavily propagandized in the past week. Most significant about the attacks is that, while small-scale and likely exaggerated, they revealed that at least some defectors were willing to fight instead of defecting and staying in Turkey or Lebanon.

It is interesting that an apparent increase in activity from armed activists — or the introduction of new forces — occurred at the same time relations between Iran on one side and the United States and Israel on the other were deteriorating. The deterioration began with charges that an Iranian covert operation to assassinate the Saudi ambassador to the United States had been uncovered, followed by allegations by the Bahraini government of Iranian operatives organizing attacks in Bahrain. It proceeded to an International Atomic Energy Agency report on Iran’s progress toward a nuclear device, followed by the Nov. 19 explosion at an Iranian missile facility that the Israelis have not-so-quietly hinted was their work. Whether any of these are true, the psychological pressure on Iran is building and appears to be orchestrated.

Of all the players in this game, Israel’s position is the most complex. Israel has had a decent, albeit covert, working relationship with the Syrians going back to their mutual hostility toward Yasser Arafat. For Israel, Syria has been the devil they know. The idea of a Sunni government controlled by the Muslim Brotherhood on their north eastern frontier was frightening; they preferred al Assad. But given the shift in the regional balance of power, the Israeli view is also changing. The Sunni Islamist threat has weakened in the past decade relative to the Iranian Shiite threat. Playing things forward, the threat of a hostile Sunni force in Syria is less worrisome than an emboldened Iranian presence on Israel’s northern frontier. This explains why the architects of Israel’s foreign policy, such as Defense Minister Ehud Barak, have been saying that we are seeing an “acceleration toward the end of the regime.” Regardless of its preferred outcome, Israel cannot influence events inside Syria. Instead, Israel is adjusting to a reality where the threat of Iran reshaping the politics of the region has become paramount.

Iran is, of course, used to psychological campaigns. We continue to believe that while Iran might be close to a nuclear device that could explode underground under carefully controlled conditions, its ability to create a stable, robust nuclear weapon that could function outside a laboratory setting (which is what an underground test is) is a ways off. This includes being able to load a fragile experimental system on a delivery vehicle and expecting it to explode. It might. It might not. It might even be intercepted and create a casus belli for a counter-strike.

The main Iranian threat is not nuclear. It might become so, but even without nuclear weapons, Iran remains a threat. The current escalation originated in the American decision to withdraw from Iraq and was intensified by events in Syria. If Iran abandoned its nuclear program tomorrow, the situation would remain as complex. Iran has the upper hand, and the United States, Israel, Turkey and Saudi Arabia all are looking at how to turn the tables.

At this point, they appear to be following a two-pronged strategy: Increase pressure on Iran to make it recalculate its vulnerability, and bring down the Syrian government to limit the consequences of Iranian influence in Iraq. Whether the Syrian regime can be brought down is problematic. Libya’s Moammar Gadhafi would have survived if NATO hadn’t intervened. NATO could intervene in Syria, but Syria is more complex than Libya. Moreover, a second NATO attack on an Arab state designed to change its government would have unintended consequences, no matter how much the Arabs fear the Iranians at the moment. Wars are unpredictable; they are not the first option.

Therefore the likely solution is covert support for the Sunni opposition funnelled through Lebanon and possibly Turkey and Jordan. It will be interesting to see if the Turks participate. Far more interesting will be seeing whether this works. Syrian intelligence has penetrated its Sunni opposition effectively for decades. Mounting a secret campaign against the regime would be difficult, and its success by no means assured. Still, that is the next move.

But it is not the last move. To put Iran back into its box, something must be done about the Iraqi political situation. Given the U.S. withdrawal, Washington has little influence there. All of the relationships the United States built were predicated on American power protecting the relationships. With the Americans gone, the foundation of those relationships dissolves. And even with Syria, the balance of power is shifting.

The United States has three choices. Accept the evolution and try to live with what emerges. Attempt to make a deal with Iran — a very painful and costly one. Or go to war. The first assumes Washington can live with what emerges. The second depends on whether Iran is interested in dealing with the United States. The third depends on having enough power to wage a war and to absorb Iran’s retaliatory strikes, particularly in the Strait of Hormuz. All are dubious, so toppling al Assad is critical. It changes the game and the momentum. But even that is enormously difficult and laden with risks.

We are now in the final act of Iraq, and it is even more painful than imagined. Laying this alongside the European crisis makes the idea of a systemic crisis in the global system very real.

By STRATFOR

Is GREED still Good?

With great sadness, I have sold my beloved and well-enjoyed Bentley GT.

Ah, the reasons I have loved that motor car might take a book to describe. It was gorgeous in appearance, sublime to sit in and quite magnificent to drive – whether in town or on the open road. Perhaps best of all, other people reacted to it with real emotion. It was, for example, the only Bentley in the car park at the V Festival and I thought, even feared, that I might be in for some abuse from other festival-goers. But not a bit of it, as the couple in the VW Combi next door told me, it was the most beautiful vehicle to be seen almost anywhere and particularly in a field of indifferent Nissans and SUVs.

But somehow, selling it seemed the right thing to do given the headlines each day about how Europe is on the verge of extinction or the squeezed middle class wants to wage war not only on the benefit-claiming lower class but also on the class claiming the most benefits – which turns out to be us bankers and City folk. And so it’s gone, replaced by a humble and practical BMW 3-series, which is one of Britain’s best-selling cars. What better way to blend in with the moral masses – of course mine has a fancy engine and trim but who can tell? But, and here perhaps is the lesson from this tale, while giving up ostentatiousness and becoming ordinary has satisfied my inner puritan, it turns out that my new, smaller road presence is worse than the old extravagant one. It’s certainly much less pleasant to spend time in – gone are the opulent leathers and woods, now replaced with fake carbon-fibre trim that feels just a bit cheap. The crushing road presence of the old has been replaced by a lightweight that skits over every bump in the road – and worst of all, gone are the cheery waves and nods of respect from pedestrians and other drivers. All in all, my conclusion is that, while smaller and more efficient sounds good on paper, it doesn’t deliver in the real world.

My symbolic gesture of selling a prized possession of the fat-cat era acknowledges an empathy with the general mood in the City, which is one of austerity, caution and sobriety. But is my disappointment with the benefits of change a lesson for the financial services industry, which is at present so very keen to shed its affluent image and slim down to something more in keeping with the times?

Might it be the case that leaner businesses are not nearly as good to work in and therefore don’t attract the talent? That tighter regulation simply stifles innovation? That smaller organisations have less clout and global presence and so are less effective? And in short that the new banking world we are starting to build doesn’t do the job half as well as the old one that the world now finds distasteful? Time – no doubt – will tell, but if my experience of trading in the Bentley is an indicator, we are going to sorely miss the old world.

By Financial News

Mastering the Machine

Ray Dalio, the sixty-one-year-old founder of Bridgewater Associates, is a “macro” investor, which means that he bets mainly on economic trends. Bridgewater buys and sells more than a hundred different financial instruments around the world—from Japanese bonds to copper futures traded in London to Brazilian currency contracts. In 2007, Dalio predicted that the housing-and-lending boom would end badly. Later that year, he warned the Bush Administration that many of the world’s largest banks were on the verge of insolvency. In 2008, a disastrous year for many of Bridgewater’s rivals, the firm’s flagship Pure Alpha fund rose in value by nine and a half per cent after accounting for fees. Last year, the Pure Alpha fund rose forty-five per cent, the highest return of any big hedge fund. This year, it is again doing very well.

Many hedge-fund managers stay pinned to their computer screens day and night monitoring movements in the markets. Dalio is different. He spends most of his time trying to figure out how economic and financial events fit together in a coherent framework. “Almost everything is like a machine,” he told me one day when he was rambling on, as he often does. “Nature is a machine. The family is a machine. The life cycle is like a machine.” His constant goal, he said, was to understand how the economic machine works. “And then everything else I basically view as just a case at hand. So how does the machine work that you have a financial crisis? How does deleveraging work—what is the nature of that machine? And what is human nature, and how do you raise a community of people to run a business?”

Dalio is serenely convinced that the precepts he relies on in the markets can be applied to other aspects of life, such as career development and management. And he has enough regard for his own views on these subjects to have collected them in print. Before our meeting, he sent me a copy of his “Principles,” a hundred-page text that is required reading for Bridgewater’s new hires. It turned out to be partly a self-help book, partly a management manual, and partly a treatise on the principles of natural selection as they apply to business. “I believe that all successful people operate by principles that help them be successful,” a passage on the second page said. The text was organized into three sections: “5 Steps to Personal Evolution,” “10 Steps to Personal Decision-Making,” and “Management Principles.” The last of the two hundred and seventy-seven management principles was: “Constantly worry about what you are missing. Even if you acknowledge you are a ‘dumb shit’ and are following the principles and are designing around your weaknesses, understand that you might still be missing things. You will be better and be safer this way.”

Dalio doesn’t pretend that Bridgewater is a typical workplace, but he is sensitive to criticism. The recent media attention irked him, because, in his view, it misrepresented and trivialized Bridgewater’s culture, which he insists is central to the firm’s success. “It is why we made money for our clients during the financial crisis when most others went over the cliff,” he wrote to me in an e-mail. “Our greatest power is that we know that we don’t know and we are open to being wrong and learning.”

Part of Dalio’s innovation has been to build a hedge fund that caters principally to institutional investors rather than to rich individuals. Of the roughly one hundred billion dollars invested in Bridgewater, only a small proportion comes from wealthy families. Almost a third comes from public pension funds, such as the Pennsylvania Public School Employees’ Retirement System; another third comes from corporate pension funds, such as those at Kodak and General Motors; a quarter comes from government-run sovereign wealth funds, such as the Government Investment Corporation of Singapore. “Making money on a constant basis is the holy grail, and Ray and Bridgewater have done that,” Ng Kok-Song, the chief investment officer of the Singapore fund, told me. “They are consistently innovating—constantly soul-searching and asking, ‘Have we got this right?’ ” Kok-Song went on, “I am constantly asking myself, ‘If Bridgewater is doing this, shouldn’t we be doing the same thing?’ ”

At some hedge funds, client service is an afterthought. Bridgewater’s investors receive a daily newsletter, monthly performance updates, quarterly reviews, and conference-call briefings from Dalio and other senior executives. “When a lot of folks were very, very secretive, Ray could see the value in creating something that was more open, something that was attractive to very large streams of money,” Robert Johnson, a former senior executive at Soros Fund Management, who now runs the Institute for New Economic Thinking, said to me.

“I’m always trying to figure out my probability of knowing,” Dalio said. “Given that I’m never sure, I don’t want to have any concentrated bets.” Such thinking runs counter to the conventional wisdom in the hedge-fund industry, which is that the only way to score big is to bet the house. George Soros famously did this in 1992—selling short some ten billion dollars’ worth of sterling. A few years ago, John Paulson wagered hugely against U.S. mortgage bonds and made several billion dollars.

What accounts for Dalio’s success? His colleague Bob Prince describes him as “a big-picture thinker connected to a street-smart” trader. Many economists start at the top and work down. They look at aggregate statistics—inflation, unemployment, the money supply—and figure out what the numbers mean for particular industries, such as autos or tech. Dalio does things the other way around. In any market that interests him, he identifies the buyers and sellers, estimates how much they are likely to demand and supply, and then looks at whether his findings are already reflected in the market price. If not, there may be money to be made. In the U.S. bond market, Bridgewater scrutinizes the weekly U.S. Treasury auctions to see who is buying—American banks, foreign central banks, mutual funds, pension funds, rival hedge funds—and who isn’t. In the commodities markets, the firm goes through a similar exercise, trying to figure out how much demand is coming from corporations and how much from speculators. “It all comes down to who is going to buy and who is going to sell and for what reasons,” Dalio explained.

To guide its investments, Bridgewater has put together hundreds of “decision rules.” These are the financial analogue of Dalio’s Principles. He used to write them down and keep them in a ring binder. Today, they are encoded in Bridgewater’s computers. Some of these indicators are very general. One of them says that if inflation-adjusted interest rates decline in a given country, its currency is likely to decline. Others are more specific. One says that, over the long run, the price of gold approximates the total amount of money in circulation divided by the size of the gold stock. If the market price of gold moves a long way from this level, it may indicate a buying or selling opportunity.

In any given market, Bridgewater may have a dozen or more different indicators. However, even when most or all of the indicators are pointing in a certain direction, Dalio doesn’t rely solely on software. Unless he and Jensen and Prince agree that a certain trade makes sense, the firm doesn’t make it. While this inevitably introduces an element of human judgment to the investment process, Dalio insists it is still driven by the rules-based framework he has built up over thirty years. “When I’m thinking, ‘What is going on today?,’ I also need to make the connection to ‘How does what is happening today fit into our framework for making this decision?’ ’’ he said. Ultimately, he says, it is the commitment to systematic analysis and systematic investment that distinguishes Bridgewater from other hedge funds. “I hear a lot of people describing what’s happening today without the proper historical context and without the framework of how the machine works,” he says.

Bridgewater’s decision rules surely contribute to his firm’s success. But Dalio also believes that his management principles play a role. “What is a typical organization?” he asked me one day. “A typical organization is one where people are walking around saying, ‘This is stupid, this doesn’t make sense,’ behind each other’s backs.” In support of his management theories, Dalio has an expert witness. “About eighty-five per cent of what’s in the Principles could be documented and supported by research,” Bob Eichinger, an organizational psychologist who has done consulting work for Bridgewater and other large companies, said. Eichinger went on, “Is it a better way to run a company? From a results perspective, probably so. Could a large portion of the working population be comfortable in that environment? Probably not.”

This spring, he told me that economic growth in the United States and Europe was set to slow again. This was partly because some emergency policy measures, such as the Obama Administration’s stimulus package, would soon come to an end; partly because of the chronic indebtedness that continues to weigh on these regions; and partly because China and other developing countries would be forced to take drastic policy actions to bring down inflation. Now that the slowdown appears to have arrived, Dalio thinks it will be prolonged. “We are still in a deleveraging period,” he said. “We will be in a deleveraging period for ten years or more.”

Dalio believes that some heavily indebted countries, including the United States, will eventually opt for printing money as a way to deal with their debts, which will lead to a collapse in their currency and in their bond markets. “There hasn’t been a case in history where they haven’t eventually printed money and devalued their currency,” he said. Other developed countries, particularly those tied to the euro and thus to the European Central Bank, don’t have the option of printing money and are destined to undergo “classic depressions,” Dalio said. The recent deal to avoid an immediate debt default by Greece didn’t alter his pessimistic view. “People concentrate on the particular thing of the moment, and they forget the larger underlying forces,” he said. “That’s what got us into the debt crisis. It’s just today, today.”

Dalio’s assessment sounded alarmingly plausible. But when one plays the global financial markets a thorough economic analysis is only the first stage of the game. At least as important is getting the timing right. I asked Dalio when all this would start to come together. “I think late 2012 or early 2013 is going to be another very difficult period,” he said.

By John Cassidy (Full article in The New Yorker)

European Vision in Trouble?

In the context of the ongoing European financial crisis, the issue is not simply whether the euro survives or whether Brussels regulators oversee aspects of the Italian economy. The fundamental issue is whether the core concepts of the European Union remain intact. It is obvious that the European Union that existed in 2007 is not the one that exists today. Its formal structure appears the same, but it does not function the same. The issues confronting it are radically different. Moreover, relations among the EU nations have a completely different dynamic. The question of what the European Union might become has been replaced by the question of whether it can survive. Some think of this as a temporary aberration. We see it as a permanent change in Europe, one with global consequences.

The European Union emerged with the goal of creating a system of interdependency in which war in Europe was impossible. Given European history, this was an extraordinarily ambitious project, as war and Europe have gone hand in hand. The idea was that with Germany intimately linked to France, the possibility of significant European conflict could be managed. Underpinning this idea was the concept that the problem of Europe was the problem of nationalism.

National identity was as deeply embedded in Europe as elsewhere, and historical differences were compounded by historical resentments, particularly those aimed toward Germany. The real solution to European wars was the creation of a European nation, but that was simply impossible. The European Union tried to solve the problem by retaining both national identity and national regimes. Simultaneously, a broader European identity was conceived based on a set of principles, and above all, on the idea of a single European economy binding together disparate nations. The reasoning was that if the European Union provided the foundation for European prosperity, then the continued existence of nations in Europe would not challenge the European Union. Perhaps, over time, this would see a decline of particular nationalisms in favor of a European identity. This assumed that prosperity would cause national identity and tensions to subside. If that were true, then it would work. But there is more to Europe politically speaking than an enhanced trading area, and the economics of Europe are hardly homogeneous.

The European project is failing at precisely the point that it had been attempting to solve — nationalism. The ability of leaders to make deals depends on authority that is slipping away. The public has not yet clearly defined the alternatives, but that process is under way. It is similar to what is happening in the United States with one definitive exception: In the United States, the tension between mass and elite does not threaten to disintegrate the republic. In Europe, it does.

Europe will spend the next generation sorting through this. Whether it can do so remains to be seen — though I doubt it. We know the tensions between nations and between elites and the public will redefine how Europe works. Even if things do not get any worse, the situation already has been transformed beyond what anyone would have imagined in 2007. Far from emerging as a unified force, the question will be how divided Europe will become.

By George Friedman STRATFOR Global Intelligence

“He who suffers much will know much” Greek Proverb

The 28th of October the day last week when the final details of the EU haircut/bailout meeting were released was ironically a very important Greek holiday. It is the day in 1940 when Benito Mussolini presented the Greek prime minister/dictator Ioannis Metaxas with an ultimatum allow Axis forces to occupy strategic parts of Greece or face war. Metaxas answer was a simple “oxi”. Oxi pronounced oh-hee in Greek means NO. This was the beginning of WWII in Greece. The Italians however never really fought hard against the Greeks they were not particularly interested in battle. More than likely they all sat around having coffee together in the town squares. It was the German forces that ultimately came through Greece a year later and ravaged the country. And after the end of WWII, there was no reprieve for Greece it became the centre of the cold war battle.

From 1946 to 1949, a British and ultimately US-backed fight against communism displaced over 15 percent of the population and generated more casualties than the German occupation. The Truman doctrine in 1947 was the beginning of US involvement in Greek government that would span 3 decades. For those that think the US will not take notice of a geopolitical crisis in Greece please reread Truman’s speech to a joint session of Congress in 1947 (Transcript).

Importantly, Communism was outlawed in Greece in 1947 and communist fighters against the Axis in WWII were declared enemies of the state. The battle between the left and right in Greece divided the country for decades and tore the country to shreds. During the 50s 12 percent of the population left Greece (including my father who walked off a Greek naval ship in New London CT in 1958). Many of the communist fighters and their children retreated into eastern bloc countries.

Greece entered NATO in 1952, and the right wing was largely in control with strong American financial backing. The move to the right culminated in a military coup in 1967 that lasted until 1974. During that period, many of the remaining left wing sympathizers were imprisoned and/or deported. The fall of the dictatorship in 1974 opened up Greece’s entry into the EU. It applied for EEC membership in 1975 and entered in 1981. Also in 1975 Andreas Papandreau formed PASOK, the modern day socialist party in Greece. Further, the communist party was legalized and a new constitution that guaranteed individual rights and free elections was put in place. Importantly, it was not until 1975 that Greece even had a democracy post WWII. In 1981, PASOK took control of the government and allowed communist fighters from WWII to return from the eastern bloc to reestablish their estates. These fighters and many others that fought through the struggle with fascism were awarded generous state pensions. It was Andreas Papandreou in the 1980s who took Greece down the path of excess political patronage, excess debt and unsustainable budgets. It was a massive wealth redistribution process that not only came from within Greece, but more importantly from within the European Economic Community (the EEC).

Papandreou threatened leaving NATO and the EEC to secure constant funding from the West. In fact, in 1985, he blocked the admission of Spain and Portugal into the EEC until he was given nearly 30 billion in EEC funds. Jaques Delors finally caved! There is a constant and overriding theme in post WWII Greek politics: the world has used Greece as a pawn, and hence the world owes us. The Germans, the British and the Americans kept Greece from democracy and freedom until the late 70s. It suited their wartime aspirations. And while we in the US were going through the Reagan revolution in the 80s, the Greeks were still trying to right the many perceived wrongs from the WWII and Cold War battles. Much of Greece’s debt troubles can be traced back to reparations for the tragedies associated with those two wars. There are strong senses of entitlement, retribution and redistribution that have taken Greece down this path of excess debt for the last 30 years. The political culture of redistribution that came with freedom in the 1980s, morphed into a culture of unsustainable state entitlement.

With this political backdrop, the endgame for Greece is extremely complex. Austerity will not last in Greece, and the threat of exit will ultimately be used by the citizens of Greece to attempt to secure a continuation of the welfare state. The stakes are high, and Angela Merkel is no Jaques Delors. The next chapter for Greece will be exit, and the losses to Western creditors will be seen rightly or wrongly in Greece as just part of the payback.

By David Zervos (Jeffries & Co.)

Guest Column: The Failure of Risk Management

The way portfolios are constructed traditionally reflects a mismatch between reality and academic hypothesis – especially the so-called efficient market hypothesis, notes Athanasios Ladopoulos, partner at Swiss Investment Managers and senior fund manager of the Directors Dealings Fund.

Efficient market hypothesis posits the existence of non-correlated markets. Reality suggests there is no such thing, partially due to globalisation of capital as well as due to what we came to call “crowded trades”. In times of crisis equity assets in particular converge to 1 – or absolute correlation.

The core idea in portfolio construction is that we can increase our expected returns by diversifying capital among what we came to call non-correlated assets. But in the absence of non-correlation, diversification isn’t the panacea it’s meant to be. Diversification might work in good times – say between 2001 to October 2007 – but has proved a failure in bad times, such as the period between October 2007 and as recently as January 2010.

In a bull market, the effect of diversification is to limit performance. Because a diversified fund will be exposed to some indices that do better and some that do worse, it will eke out an average return somewhere between the two, meaning that in good times it will underperform. In bad times it will do the same as everyone else because the correlation is 1.

In bad times, too, the ‘efficient frontier’ and ‘optimal portfolio’ constructions become inevitably a function of leverage. In other words, leverage begets the greater part of outperformance, not stock picking or the fund manager’s skills. This, of course, introduces a variety of new risks and problems, not least of which is how you hedge when leveraged. In the long run leveraging will only buy more under-performance.

Diversification, portfolio insurance, hedging with futures on a portfolio level, and pair trades are the four major ways to hedge across many investment strategies.

The problem, at a basic level, is that the notion of hedging is borrowed from another industry: the insurance industry. If you own a house, for instance, you buy insurance against fat tail risk – in this casesubsidence. For a monthly cash outflow, you are guaranteed that in the case of subsidence, your house will be repaired and made new by the insurance company.

This doesn’t quite work in the fund management industry. A fund that is 80% net long, for instance, is paying every month for a hedge position that isn’t guaranteed to cover it completely during an unexpected downturn – fat tail risk. But the effect of that monthly hedge payment is to ensure that the fund will underperform in good times. Obviously, if the fund is leveraged it is bleeding cash each and every month to pay for shorts. Leverage introduces further risk and reduces further the theoretical protection offered with diversification.

Just like long-biased funds, market neutral funds will underperform. In a crisis, what can happen is the fund turns out to be not market neutral at all. It is very, very complicated thing to be market neutral and it doesn’t create a profit.

As for pair trading, it operates within the efficient market theory. When a trader decides that a particular equity is overvalued, he is assuming, first, that he’s right and the market is wrong (which can happen) and, second, that from the point he takes his position the market will realise it was wrong and revert to the mean. That is less likely to happen, as markets can remain inefficient for longer than you can remain solvent, as John Maynard Keynes once pointed out.

Developed in the ‘70s, portfolio insurance relies on options to reduce volatility and give some form of protection. But there are drawbacks in setting them up. They’re expensive; the implied volatility of the security`s price reflected in the option could increase or decrease, and the time value of the option will decrease as it approaches the exercise day or period; and it introduces an element of uncertainty, the enemy of an efficient trade.

Options, fundamentally, introduce new elements of risk – specifically of strike price and time duration. The concept of reducing risk by introducing new forms of risk is an odd one, akin to the notion of fighting fire with fire. Sometimes it works. Often it doesn’t.

From 2007 to 2009, market correlation increased as international capital flows boomed. The search for a Holy Grail of truly diversified assets rapidly became equally legendary. Conventional diversification or portfolio insurance can not provide significant protection without significant time lag and cost.

At the same time, traditional pair trading – developed from the arbitrage generation – as well as shorting futures to protect directional portfolios does little to provide investors with sustainable, risk-adjusted, real returns. Hence a fresh approach to risk and money management is necessary, avoiding the herd mentality and relying on more counter-intuitive investment strategies.

By Athanasios Ladopoulos is a partner at Zurich-based Swiss Investment Managers (SIM) and senior fund manager of the Directors Dealings Fund.