Stocks had a bumpier-than-expected ride in 2018, ending in the worst fourth-quarter performance of the S&P 500 in a decade. Culminating in a disastrous December, many industry and political leaders began talking openly about the possibility of an imminent bear market -- or even a recession. Such talk had been kept to the fringes of public discourse for years, yet the year-end selloff threatened full-blown panic.
Even the pros were taken by surprise. Indeed, some of the most well-known and respected hedge fund managers posted terrible returns. David Einhorn (Trades, Portfolio)’s Greenlight Capital, for example, posted its worst result in its 22-year history, as we discussed in a January research note. But Einhorn was far from alone. All hedge funds, across virtually every strategy classification, did poorly in 2018.
Despite the carnage that spread across the hedge fund sector, some funds managed to thrive.
Surprising winner
In a twist that surprised many market observers, Bridgewater Associates’ Pure Alpha Fund was among them. It was an impressive performance by the world’s largest hedge fund manager.
The Pure Alpha Fund is Bridgewater’s flagship hedge fund. Pure Alpha delivered an impressive 14.6% return for the year net of fees. That is significantly better than the average annual return in the S&P 500, and a whole lot better than the 7% loss that index posted in 2018. It is also better than the Pure Alpha Fund’s own average: During the nearly 30 years the fund has been in operation, it has posted a 12% annualized return with just three years ending in the red.
Despite Bridgewater’s long track record of success (and the legendary status of its founder, Ray Dalio (Trades, Portfolio)), there had been wide perceptions that the venerable fund was having trouble. Specifically, the issue of Dalio’s succession has plagued the fund manager for years. But, in 2018 at least, those internal power struggles did not stop them from doing their jobs very well indeed.
Dalio opines on the year
In a post published on LinkedIn in January, Dalio offered his explanation for Bridgewater’s surprisingly good year:
“In reaction to a lot of press about us (Bridgewater) having made 14.6% in our flagship Pure Alpha fund last year when most investments and investment managers lost money, I’ve been asked for a lot of advice. I regret that I won’t be able to adequately provide it in this limited space (though I will eventually pass along the most important principles in my upcoming Economic & Investment Principles). But I will pass along one important thought. If you are worried when the stock market goes down and happy when it goes up it probably indicates that your portfolio is unbalanced. If your income is also tied to how the economy does, you are doubly at risk because your portfolio can go down when your income is worst which is scary. Most people and companies are in that position and many make it even riskier by borrowing money to be in that position in an even bigger way. That’s what makes the financial rollercoaster ups and downs so big and dramatic. To me, the key is to not have any systematic biases by structuring your portfolios and your incomes so that they hedge each other and are in balance. Achieving good balance is the most important thing.”
A nugget of satisfaction
Dalio’s explanation does little to satisfy the reader hungry to hear how he and his team managed to defy the odds. Then again, he does run a hedge fund that charges high fees in exchange for market-beating performance. Handing over the secret sauce to anyone who asks would hardly be good business.
Still, Dalio hit on an important point when describing optimal portfolio structure. Cognitive biases, poor risk management and inadequate hedging can crush investors, whether they are ordinary folks investing their own accounts or pedigreed asset managers.
Ironically, one of the core premises of the original hedge funds was that they would offer superior returns in poor market conditions (hence the name). Few delivered on that promise in 2018, however.
Verdict
Bridgewater’s Pure Alpha Fund delivered the goods in 2018. Its bet on a global slowdown appears to have been a factor in that story, especially toward the end of the year.
As markets grow increasingly volatile and uncertain, it is critical that investors be on their guard. They should follow Dalio’s advice when it comes to hedging and risk management. Check your premises, be diligent in risk management and be flexible and adaptable to a rollicking marketplace. 2019 will definitely not be a year for complacency.
Disclosure: No positions.
Read more here:Ă‚
Sanders and Schumer Declare War on Stock Buybacks, Pt. 1Ă‚
Trouble Ahead for Growth Stocks?Ă‚
Tesla: The 3 Strangest Moments of the 4th-Quarter Earnings CallÂ
