“With fifteen to twenty good, uncorrelated return streams,

you can dramatically reduce your risks without reducing your expected returns.”

The above quote is from Ray Dalio, billionaire hedge fund manager at Bridgewater Associates.  He shared this insight in “Principles”, a lengthy tome which spells out all Dalio’s learnings from half a century in the investing industry.  [REF]

The concept of allocating to a variety of uncorrelated assets is a fundamental tenant of diversification.  But can over a dozen truly differentiated holdings be found in the public markets, and if so, how should the portfolio be constructed and rebalanced?

Let’s look at how Mr. Dalio was raised, made his money, and executed this strategy, throughout his distinguished career.  It turns out the complex hedge fund model he pioneered can be closely mimicked using low-cost exchange traded funds, a valuable tool for the modern individual investor.

The Man

Ray Dalio was born on August 8th, 1949, in the Jackson Heights neighborhood inside the Queens borough of New York City.  When Ray was 8 years old, the family moved out to the hamlet of Manhasset on Long Island in Nassau county. 

His Italian-American upbringing was decidedly middle-class, with a father who performed as a jazz musician, and a mother who stayed home as the primary caretaker.  While provided a supportive family structure, as a child there was little suggestion of the calculating mathematical mind this financial savant would eventually develop.

Dalio’s first interest in investing came while working as a golf caddie, a pursuit started at age 12.  Very observant, with a good memory, the lad was able to pick up stock tips from rich golfers who’s clubs he hoofed.  He soon leveraged these company insights to start his stock market career, parlaying overheard tips into investing wins.

A smart and ambitious youth, Ray graduated from Long Island University with a finance degree, then earned an MBA at Harvard Business School.  After college, he worked directly at the New York Stock Exchange, as well as several investment banks located in the Big Apple.  Dalio branched out on his own in 1975, founding hedge fund Bridgewater Associates, out of his small 2-bedroom apartment in Manhattan.

Over the next half century, Mr. Dalio grew the operation into a massive empire with $160 billion in assets, representing the world’s largest hedge fund, generating a personal net worth approaching $15 billion.  Not bad for a modest kid from the NYC suburbs.  Since inception, coming up on 5 decades in operation, Bridgewater has produced $50 billion in profits, at the very top of the hedge fund total return charts.

While his strategy has evolved over the years, Dalio’s core focus is global macro investing, making big bets on various asset classes, based on overarching political and economic trends.  He stepped down as CIO of Bridgewater Associates in 2022, but continues to remain active in key business and investment decisions.  [REF]

The Firm

At Bridgewater, Dalio encourages “radical transparency” amongst his employees, which involves brutally open and honest communication.  This approach fosters collaborative teamwork, but can be jarring and combative for some folks, as this leadership model is the opposite of traditional corporate hierarchies. 

This concept ties into remaining open-minded, a methodology Ray has learned the hard way through various costly investment failures over time.

“Principles” was published by Ray Dalio in 2017; this wordy offering is a culmination of his lifelong learnings as a successful investor.  The concepts in this work provide insight on optimal decision making in both work and life, through risk management and systematic thinking.

Mr. Dalio’s lengthy tenure has allowed him to identify a few key elements of strategic investing, notably “long-term cycles”, combined with “cause-and-effect relationships”.  He relies on observation and calculation to identify and exploit specific areas of the financial markets.  Ray suggests that examining history can provide valuable insights on the future trajectory of humanity.  While the past in not a perfect means of prediction, such foresight does help stay ahead of other folks who are reacting in real time.

In the “Holy Grail of Investing” section of his book, Dalio espouses the key concept of diversification, which ensures portfolio stability.  A related and recurring theme is finding uncorrelated investments, as highlighted in the following quote.

“Making a handful of good uncorrelated bets that are balanced and leveraged well is the surest way of having a lot of upside without being exposed to unacceptable downside.”

A sound investing philosophy, but how is this methodology executed in practice?  Conveniently, Dalio lays out a very detailed portfolio which takes advantage of this uncorrelated asset approach.  A strategy that has proven to be incredibly profitable over the past many decades.  [REF] 

The Strategy

The flagship fund at Bridgewater Associates in Dalio’s All-Weather Portfolio.

This novel scheme was conceived by Mr. Dalio in the mid-1990s, after he’d amassed a substantial amount of generational wealth for his family.  The laudable goal is to perform well over a multi-decade timeframe through unforeseen future economic cycles.  Essentially all Dalio’s net worth is currently allocated to this offering, along with $80 billion of customer capital. 

Despite being an expert on global macroeconomics, it became clear to Ray that every worldwide geopolitical event couldn’t be anticipated or predicted.  Thus, a more robust investment framework was necessary.

Using strategic asset allocation, with frequent rebalancing, allows steady returns over the full economic cycle.  Even more important, having an algorithmic approach avoids emotional, typically detrimental, decision making, especially when the markets are in a substantial drawdown, which is the worst time to sell.

Stocks, bonds, and commodities are 3 distinct asset classes that offer disparate performance in various business climates.  Dalio also tried to match the experienced volatility of this trio with his All-Weather offering.

This distribution balances the rise and fall in both economic growth and inflation; at least two legs of the stool will perform in each environment.  Returns are tied to key factors like corporate profitability, interest rates, and real asset demand.

Dalio’s approach, dubbed “risk parity”, aims to improve on a static, simplistic system in two ways.  Greater diversification of returns, and more consistent rebalancing.  As shown in the following pie chart, he’s adjusted capital allocation amounts to align with potential returns and experienced risk, as opposed to evenly split cash amounts.  [REF]

The Math

To understand the odd allocation percentages in the All-Weather Portfolio, it’s necessary to do a deep dive into the concept of risk parity.  This strategy focuses on matching the volatility of each asset class in a portfolio, to provide truly normalized differentiation.  This relies on determining experienced historical and anticipated future price change of each holding in a portfolio over a given period of time.

For simplicity, consider a basic portfolio of 2 assets, stocks and bonds, which are the two most common investment types available to investors.

A well-known and heavily-touted strategic allocation these days is the 60% stock and 40% bond model.  It may be surprising to know that, based on past performance, with this seemingly even breakdown, the stock holdings account for 90% of the portfolio’s overall risk.

Ideally, each of these asset classes would contribute the same amount of volatility to a portfolio.  A little math shows that to balance the risk versus returns, a 30% stock and 70% bond allocation is needed.  Which is decidedly different than the standard 60/40 model, and helps shed some light on how the All-Weather version ended up with so many bonds.  [REF] 

The Logic

Dalio’s analysis, leveraging the work of prior renowned economists, identifies 4 different “seasons” of the global economy: inflation, deflation, economic growth, economic contraction.  This approach can be back tested by examining different investment climates throughout history.

This 4-quadrant model has been repurposed by all manner of financial allocators in recent times, using various catchy descriptors.  Logically, it makes sense that an investor would want different holdings in a raging inflationary boom, catastrophic deflationary bust, or drawn-out period of economic stagnation.

Based on historical outcomes, the out or under performance of different asset classes in different economic environments is well understood.  The plot below lays out the 2-axis grid framework, then overlays investment categories that perform well in each condition on top.  [REF]

In addition, the circular format is important, as it displays the riskiness of various investments spiraling out concentrically from the center. 

As shown, cash performs well in any slowing growth environment, but doesn’t provide as beneficial a return as gold.  TIPs offer protection from rising inflation, but a more effective hedge in this environment is emerging bond spreads.

Looking at the outer red ring, the asset classes that Ray Dalio has selected, like long term bonds, stock equities, and commodities, are all present and relevant at different points in the economic cycle.

The Drawbacks

The All-Weather Portfolio, while novel in construction, and impressive in historical performance, is not perfect.  As investing disclaimers always state, past performance is not indicative of future returns.

Dalio’s flagship model relies on a negative performance correlation between stocks and bonds, which may not always be the case, especially in an inflationary environment, like the 1970’s, right before his hedge fund came to fame.  Supply shocks stemming from the COVID-19 pandemic, along with shifts toward tariffs and deglobalization, may be ushering in a new inflationary era worldwide. 

Also, this strategy has benefited from a 40-year bond bull market, with steadily lower rates, corresponding to increasingly rising prices, which started shortly after Dalio established Bridgewater.  With global government debt exploding in recent years, it seems unlikely near-zero interest rates will be seen again for a while.

Lastly, the risk parity element of the model means that this portfolio will underperform more aggressive portfolios like an all-stock allocation, especially in times of strong economic growth and favorable market returns.  To minimize this drag, Dalio’s hedge fund uses substantial leverage, a scheme that offers its own set of challenges regarding implementation and management.

Mr. Dalio’s strategy, like any volatility management system, in not a panacea.  Any time risk is mitigated, returns are marginalized.  At least in the short term.  The real question is how to achieve both core investment tenants at the same time.  [REF]

The Correlation

The S&P 500 equity and Barclays aggregate debt are the indices that make up the generic 60% stock and 40% bond portfolio, which is the benchmark for many American investors.  As shown in the graph below, even the relationship between ETFs representing these typically divergent asset classes has varied widely over the past few decades.  [REF]

A correlation value of +1 corresponds with a pair of data sets that move in perfect unison, while a denomination of -1 is related to exactly inverted performance. 

As shown, while generally inversely linked, stocks and bonds reach correlation values approaching +0.5, in times of extreme market stress, like October 2008, and March 2020.  Thus, these generally deviating assets trend together in times of crisis.

It’s also interesting to note that since the March 2020 pandemic, the correlation has been positive more often than not.  This finding is in stark contrast to the decade of the 2010’s, during which the calculated value was persistently below -0.25, aside from a few brief spikes.  Clearly, some major market shifts are afoot with regards to asset class alignment.

Considering this variable yet linked relationship between stocks and bonds, its essentially impossible to find 15 reliably and consistently uncorrelated assets in the publicly traded markets.  Especially unique holdings that maintain their differentiation powers in times when financial shit really hits the fan.

Essentially, all investments in the stock market are inherently tied, liquidity and sentiment both influencing the propensity for investors to deploy new capital or sell existing holdings.

Also, within each individual asset class, there isn’t really that much diversification provided.  Oil drillers and refiners.  Multinational and regional banks.  Semiconductors and cloud computing.  Aside from idiosyncratic, company-specific, considerations, equity performance of entire sectors tends to move in lockstep.

Dalio even acknowledges this fact in the following quote from “Principles”.  

“Individual assets within an asset class are usually about 60% correlated with each other,

so even if you think you’re diversified, you’re not.”

There are all sorts of examples where two different assets are negatively correlated, often being polar opposites in performance profile: real estate and interest rates, oil price and airline stocks, the U.S. dollar and emerging market equities.  However, if one allocation is soaring, while the other tanking, than doesn’t equate to a successful diversification strategy.

Having access to private market investments, available to many university endowments and pension systems with large amounts of capital, diversification becomes easier.  But these private holdings have high minimums, lengthy holding periods, and exorbitant fees.  Not ideal for the average individual investor.  

Another challenge is that asset correlations change over time, due to a wide variety of macroeconomic and geopolitical factors.  As a result, the risk parity investing approach, like any in the rapidly moving modern era of finance, is constantly evolving.

The Execution

So, how can the average individual investor implement Mr. Dalio’s sophisticated hedge fund strategy?  Or maybe even improve on the model, leveraging newly created trading tools.

Using low-cost ETFs for each of the asset classes in the All-Weather Portfolio, and frequently rebalancing to the recommended allocation amounts, it’s fairly easy to replicate Dalio’s original system. 

In fact, 5 tickers, SPTL, BKLC, VGIT, IAUM, COMB can mimic the holdings of the All-Weather model.  These funds have a weighted average expense ratio of just over 4 basis points when applied in the prescribed percentages.  With free trading on most online brokerage platforms these days, individual investors can deploy fundamental Ray’s risk parity approach simply and cheaply.  [REF]

What’s of more interest is to examine if the holy grail of 15 truly uncorrelated investments can be achieved.  Each asset in the portfolio must have two key characteristics: moving independently from all others, and having a positive expected return.

While the approach sounds simple, finding over a dozen assets that are completely disparate in return profile is not easy.  Otherwise, everyone would be employing this strategy.

The Minutia

Investment risk is most effectively minimized through diversified optionality.  As the famous historical saying goes, “don’t put all your eggs in one basket.”  This quote is just as relevant for surviving in a pioneer homestead as it is for surviving major financial shocks.

Risk management is a critical element of avoiding large drawdowns; a 20% loss requires a 25% gain to break even, while dropping half one’s bankroll necessities a doubling to get back to square.   

With effective diversification, there the potential to have an 80% reduction in overall portfolio risk, without sacrificing any of the returns.  Is this approach truly a free lunch?  What asset classes can provide this desired reliable dispersion?

The chart below shows the market returns of 3 separate U.S. asset classes, stocks, bonds, and managed futures, for the entire 21st century to date.  [REF]

There’s a lot of relevant information about investment diversification contained in this single diagram.  First, the timeline is broken into bull and bear market periods, with the performance of each asset calculated for each identified period.

As shown, in bear markets, defined by a 20% plus drop in stock valuation, both bonds and managed futures, a broad basket of investments made based on prevailing market trends, tend to rise. 

The substantial 2008 “Great Recession” and most recent 2022 drawdown, are especially telling, as managed futures performed well, while bonds were flat to down, especially in 2022.  This performance helps to explain why many capital allocators label managed futures “crisis alpha”.

Thus, this trio of assets, stocks, bonds, and managed futures, represents an excellent starting point for a diversified portfolio. 

The one economic quadrant that hasn’t occurred much in America since the turn of the millennium is stagflation, which is characterized by slowing growth and rising inflation.  In this situation, assets like gold offer the best preservation of capital.  And are thus a valuable tool to complete a robust risk parity strategy.

The Basic

Taking the All-Weather portfolio as a starting point, then utilizing some recent financial innovations, allows for a clean and simple diversified allocation to be generated.  Namely leveraged exchange traded funds and modern-day asset classes.

With the 4 key building blocks identified, the recent proliferation of ETFs allows a truly targeted allocation to be created.  There are even prepackaged funds that offer leveraged exposure to some of these differentiating components.  However, it’s important to hold at least some of each asset on its own, to allow for timely rebalancing, a core element of Dalio’s All-Weather approach.

The table below shows a simple portfolio of 6 ETFs which should perform well across any economic conditions encountered in the future.

This allocation results in a portfolio with a 0.89 net expense ratio and 1.8X total leverage.  The selected percentages yield roughly 45% of overall exposure to the 4 differentiated asset classes: stocks, bonds, managed futures, and currencies. 

The use of leverage makes these selections a little more costly, but allows capital to be put to work more efficiently.  It should be noted that of all these funds, UPRO is probably the most inappropriate for long-term holding, both due to the 3 times leverage, and the daily reset timing.  As extended timeline leveraged ETFs come out in the future, this fund can be swapped out.  [REF]

The choice to go with an equal weight strategy by asset class, rather than true risk parity based on experienced volatility, has been made for several reasons.  Historical market data orders these asset classes in terms of volatility as follows: stocks, managed futures, bonds, currencies.

However, a few tweaks to typical performance properties have been made during the ETF selection process, in an effort to balance volatility. 

CTA is one of the higher risk offerings in the managed futures space, with extra leverage already embedded.  Also, as previously discussed, bonds yields have trended steadily downward for the past 4 decades, nearing the lower bound in 2020; total returns experienced will likely be much more variable in coming years.  Lastly, high-octane bitcoin has been added to the relatively mundane gold allocation, providing the opportunity for wide swings, both up and down, to the typically slow-moving currency class.

Based on these considerations, an evenly distributed 0.45 beta exposure to the quartet of differentiated asset categories seems reasonable and well balanced.  

From an operational standpoint, the two blended ETFs highlighted in grey represent core holdings that don’t change.  The remaining 4 single asset funds allow rebalancing as needed and desired.  As discussed, similar volatility is expected across these various holdings long term. 

One scheme is a percentage-based adjustment, rebalancing automatically at set levels of 20%, which roughly represents the expected annual change in prices.  Another option is a quarterly or yearly rebalance at set dates, with all holdings simply adjusted back to their original allocation percentages.  Both options are easy to set up and automate on most brokerage portals.

The Complex

As discussed, the true holy grail espoused by Ray Dalio is 15 uncorrelated assets.  Considering the constraints of the public markets, how achievable is this unicorn allocation?  Time for a deep dive into the ETF space, and a bunch more math.

Currently there are over 3,500 ETFs offered on exchanges in the United States.  Amazingly, this is roughly the same quantity as the number of publicly traded stocks with market capitalization over 250 million, the rough lower bound of delineation for a small cap company.

Obviously, each exchange traded fund doesn’t hold a single corporation, so there’s clearly a substantial amount of variety in the ETF landscape, with product creators looking to provide differentiated and unique offerings.  Considering this wealth of opportunity, there must be some differentiation available. 

Perusing the entire ETF universe, leveraging valuable online screening tools, provides some insight on dispersion opportunities.

In addition to providing extreme divergence, each ETF must pass a few key selection metrics: expense ratio under 0.85%, assets under management above $500 million, fund tenure of at least 4 years, except in the case a few new categories, like cryptocurrency and managed futures. 

These parameters help verify the selected funds are robust, trade easily, and will be around for a while.  A final consideration is diversifying across ETF creation companies, to avoid any single issuer risk or overlapping corporate strategies.

The table below shows the 15 chosen ETF tickers, with their correlation to all other holdings in the created portfolio listed.  This analysis uses monthly returns, and a 12-month rolling average, dating back to the middle of 2019, when the newest fund of the group, DBMF, was launched.  [REF]

Per the prior matrix, no pairing of combined ETFs exhibits a correlation above 0.8.  This feature ensures that some funds will zig, while others zag, across a variety of market conditions.

Also displayed are the annualized returns for each ticker over the past 4+ years.  While a few offerings, namely long-term U.S. government bonds and global real estate, are negative over this recent period, in the long run it’s expected that the assets underlying each of the 15 ETFs will be positive.

The far-right column identifies the calculated annualized standard deviation for each symbol.  This number is related to how volatile the price of the holding is over time; as shown, the line items in this assembled portfolio display a broad swath of volatility characteristics.  For reference, the historical standard deviation of AGG bonds is roughly 5%, with VOO stocks 3 times higher at 15%.

Near the bottom of the grid, a long-running mutual fund, MFTFX, has been used to mimic the high-volatility managed futures space covered by newish ETF CTA.  Also, the historical bitcoin exposure is mimicked by GBTC, a proxy stock holding that can now be cheaply replicated with ETF FBTC.

The full 15 holding ETF portfolio breakdown of fund ticker, family, and name is defined in the table below, along with the expense ratio, net AUM, and asset class, all factors that were used for the screen.  Broad market proxies for bonds and stocks, AGG and VOO respectively, are also provided to allow comparison.

Sure, these ETFs cover a wide range of interesting sub-asset classes, but are they truly divergent with regards to performance?

Conveniently, since 2020, the broader U.S. stock market has offered up a pair of substantial bear and bull markets, over just the past 4 years.  This volatile performance of late provides a convenient way to test the differentiating properties of these offerings in real time.

The positive and negative periods have been identified by the performance of the S&P 500, a broad proxy for the equity market.  Based on these dates, the performance of the selected and differentiated ETFs in each cycle is displayed.

As expected, many of the stock-like holdings mimic the broader market, with quick drops during the bears, and prolonged rise during the bulls.  However, as hoped, there are a few key differentiating outliers in the portfolio.

Given the wide range of volatility values shown in the matrix, rebalancing is key for effective execution of this risk parity strategy.  Most of these ETFs exhibit annualized standard deviations between 10 and 30.  For these, setting limit orders these levels, in 5-point increments, should result in rebalancing approximately 70% of the time over a typical calendar year.

As previously noted, there are few volatility outliers in the portfolio, ultra-short-term bonds on the conservative side, and bitcoin cryptocurrency from a risky standpoint. 

In this portfolio, the ICSH fund is a cash proxy, that can be used to enable the various reallocation activities.  In contrast, FBTC needs to be given a longer leash, on both the positive and negative sides of ledger.  A 50% rebalance level, which seems absurd for most normal asset classes, is probably a reasonable starting point.

The Conclusions

With 15 different asset classes of widely varying volatility, it gets cumbersome to try precisely matching return profiles.  As a result, the equal weighting of 6.67% for each ETF in the portfolio has been employed. 

One option for a more aligned risk vs. return profile strategy is to use futures, which are inherently leveraged, as opposed to ETFs, with portfolio holding percentages inversely linked to the historical standard deviations of each unique asset class.  An execution that’s likely too complex for the typical individual investor.

Also, for a sufficiently large account balance, branching out from publicly traded funds to venture capital, private debt, real estate, and even exotic investments like collectables, could certainly provide the elusive uncorrelation.  This is a much more multifaceted approach, worthy of its own exploratory post in the future.

In contrast, for the truly lazy investor, there are many one-stop-shop balanced portfolio offerings these days. 

Most relevant to the All-Weather Portfolio is UPAR, a clever ETF ticker nod to Dalio’s risk parity philosophy.  Sporting a 0.67% expense ratio, this fund provides 120% leveraged access to global equities, commodities, gold, bonds, and inflation protected securities, each held in allocations that balance expected risk and return profiles.  [REF]

An additional benefit of the risk parity approach is that it can offer a smoother ride, which helps investors not panic during times of market tumult.  Historical metrics touted by Dalio’s All-Weather Portfolio since inception are impressive: volatility below 8%, maximum drawdown of just 15%, with only 6 losing calendar years during the now-half-century in existence.

Granted 2022, when both long-duration bonds and diversified equities fell double digits at the same time, highlights the challenges with even the most robust and diversified allocation approach.  The key for motivated practitioners is to keep learning and innovating as financial tools and market conditions continue to evolve.

Each individual investor’s risk tolerance is different, based on account balance, performance needs, and time horizon.  It’s important to implement a portfolio which aligns with these specific factors.  Most importantly, pick an investment solution which you have enough time to manage, and let’s you sleep at night.

Mr. Dalio is likely able to rest quite comfortably atop his piled up $15 billion bed of money.  Graciously, like many ultra-rich these days, Ray and his wife Barbara are part of the “Giving Pledge” movement started by the Gates family and Warren Buffett, vowing to pass along the majority of their net worth to valuable causes before death.

Undoubtably, the donations Dalio makes in coming years will be spread broadly across a diverse set of uncorrelated philanthropic endeavors.

The Resources

• Simple economic quadrant model with historical asset class and 60/40 performance.  [REF]

• Website creates a full matrix of correlation between input trading tickers.  [REF]

• Podcast “Risk Parity Radio” provides ideas and strategies related to this investment approach.  [REF]

• Dalio family’s “Giving Pledge” commitment and fields of passion.  [REF]

Disclaimer: This article is for informational purposes only; investments or strategies mentioned may not be suitable for everyone, and the material does not consider individual objectives or financial situations.  The author may own shares of some of the funds discussed.