2018 proved an extremely challenging year for many Hedge Funds. Initial data from Hedge Fund Research showed the average fund lost 6.7 percent in 2018. However, significantly bucking this trend was the world’s largest and most successful hedge fund Bridgewater’s Associates’.
Bridgewater’s flagship ‘Pure Alpha’ fund put in a stellar performance achieving a return of close to 15% for the year net of costs. This maintains their outstanding performance over the nearly 30 years of its existence which has seen average returns of 12%.
This performance is even more remarkable when one considers the colossal size of Bridgewater. Conventional wisdom is that there is that sustainable out-performance becomes harder the larger the fund.
So, what is there secret?
Bridgewater’s not so secret ‘Secret Sauce’: Its ‘Behavioural Edge’.
Many firms like to keep their ‘secret source’ hidden, yet Bridgewater are completely open about the source of its success. It’s founder, Ray Dalio regularly writes about it, blogs about it and talks about it.
Bridgewater’s success can be largely attributed to two key factors:
- Their investment strategy: ‘Reducing and synthesizing complex systems into interdependent stocks and flows underpinned by cause and effect relationships’. It’s a machine or quant type approach to investment.
- Their ‘behavioural edge’ and culture: This is built around key principles which underlie everything the firm does and which they almost religiously adhere to. Bridgewater are always learning about themselves and how they interact with their external environment.
The first factor is not necessarily unique to Bridgewater, however, the second aspect is unique to Bridgewater. It is something they work incredibly hard to develop and which has proved to provide a significant ‘Behavioural Edge’.
Their ‘behavioural edge’ seeks to capture the upside of human ability, such as high-quality decision-making, pattern recognition, creativity, ability to abstract. It also seeks to reduce the negative aspects of human frailties, such as ego, hubris, biases and mental shortcuts.
Sun Tzu in the ‘The Art of War’ says “If you know the enemy and know yourself you need not fear the results of a hundred battles.” – Bridgewater’s approach means they have a high level of intelligence on its enemy; the market, and on itself. – This gives them a key edge in the battle to win and succeed in the investing world. .
“If you know the enemy and know yourself you need not fear the results of a hundred battles.” – Sun tzu, The Art of War.
It is this unique edge which has enabled Bridgewater to thrive, grow and continue to perform so strongly. Factor 2, their behaviour, impacts an underlies Factor 1, making it more productive and effective.
In light of Bridgewater’s decades of success, it might be fair to assume that others may have tried to imitate Bridgewater. Yet, to my knowledge, no other firm seeks to emulate Bridgewater’s behavioural approach, or anything close to it.
If anything, people seem to slightly deride Bridgewater’s approach. An article some years ago, though written from a favourable perspective, described Dalio as ‘Wall Street’s Oddest Duck‘.
Why has Bridgewater’s approach not been imitated?
A ‘Behavioural Edge’ help contribute to better decision-making and improved execution of strategy. Bridgewater’s ‘Behavioural Edge’ helps them by:
- Minimising the impact of behavioural biases
- Reducing ego-driven behaviours.
- Countering over-confidence.
- Improving risk management effectiveness.
- Having a more objective and realistic assessment of markets and ideas.
- Calibrating improved decision-making processes.
- Creating automated decisions-making aids and algorithms.
As a result, the ‘Behavioural Approach’ helps power a culture of excellence.
This brings me back to this question of ‘why aren’t others trying to emulate their approach’?
I believe there are a number of core reasons as to why this is:
- They do not share Dalio’s philosophy: The approach at Bridgewater is built around Dalio’s own personal philosophy. Dalio has imbibed his beliefs through the firm, it has become built into the walls, structure and foundations of the firm.
- Most firms focus on their specialisms: Most leaders in this industry tend to focus on specialisms such as Investing, Risk Management, Quantitative Finance, Data Analysis, etc. Behaviour is rarely given a high emphasis.
- An approach to behaviour which is outward looking: It would be wrong to say that the industry does not consider behaviour, it is just that the focus on behaviour is typically looking at the behaviours of others. e.g. Market behaviour, Investor behaviour. – Whereas Bridgewater turns the behavioural spotlight on itself.
- A behavioural approach requires a long-term perspective: The Hedge Fund industry focuses primarily on short-term results. Adopting a behavioural approach requires a longer-term perspective.
- The intangible nature of behaviour: Trying to attribute returns on a behavioural approach is an almost impossible achievement. There is a leap of faith required to believe that focusing on behaviour and culture will generate an additional return. This is despite a weight of evidence that focusing on behaviour and culture adds huge value.
It is combination of these factors which means that most firms pay scant attention to behaviour, and which thus leaves the field open for Bridgewater.
Developing ‘People Alpha’.
In a world where trying to build a sustainable advantage is increasingly hard, working on developing ‘behaviour’ is one of the few frontiers where a marginal advantage can be built. This was brought home starkly in a fascinating piece of research carried out by Citi Prime Finance *.
Over a period of 3 years the researchers analysed the ‘People Practices’ of a large group of hedge funds. They found that hedge funds that invested in superior people management processes registered higher investment returns, compared to firms that put less emphasis on these processes.
The research allocated a ‘people score’ to hedge funds dependent on various aspects of their processes. It found that firms with between 50 and 150 people that fell into the bottom half of the ‘people score’, underperformed firms of the same size in the top half by nearly 600 basis over a 3 year period. That is not a marginal difference, that is a huge difference.
The research calls this impact ‘People Alpha‘, differentiating it from ‘Operational Alpha’.
If we go back to the two chief factors of Bridgewater’s success. It is clear, the first major factor which contributes to their success is their ‘investment strategy’, their operational alpha. It is the second factor, their ‘behavioural edge’, that clearly relates to ‘People Alpha‘.
For this reason, I believe that the winners of the future in the Hedge Fund industry will be firms that start to build their ‘behavioural capability’.
As things stand, Bridgewater will probably have the field to themselves on behaviour for many years to come. However, firms looking for a new and future edge that can take a longer-term perspective, should consider a second look at developing their ‘behaviour’.
* Exploring the Concept and Characteristics of “People Alpha” http://www.focuscgroup.com/wp-content/uploads/2015/11/People_Alpha.pdf
At Alpha R Cubed we work with businesses in the financial markets to help them explore how they could help improve and develop behaviour. We work with firms, their leaders and their people to develop and construct behavioural development programmes which can catalyse stronger and more effective performance.
If you are curious about how we could help you, please call us or email me at steven.goldstein@alpharcubed.com.
