BRIDGEWATER ASSOCIATES
Alpha Wars: Survival of the Fittest
Bob Prince
Co-Chief Investment Officer
October 2005
One Glendinning Place
Westport, CT 06880
(203) 226-3030
www.bwater.com
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TWO WAYS TO MAKE MONEY
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Hold Assets
(risk premium)
Make Bets
(timing)
Beta
Alpha
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Alpha vs. Beta
Beta
Alpha
Type of risk:
Systematic
Unsystematic
Source of risk:
Asset class
Manager skill
Return/Risk
ratios:
0.2 to 0.3
Unlimited
Correlation:
High
Low
Difficulty:
Easy
Hard
Cheap
Expensive
Cost:
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THE ALPHA WORLDS ARE CONVERGING
Alpha is a zero sum game, no matter what you call it.
 Weaker players will lose to stronger players.

Alpha Overlay
Hedge Funds
Active Management
Traditional
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THE WINNERS WILL BE…
SMARTEST
Make good bets
BEST RISK MANAGERS
Portfolio theory applied to alpha
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APPLYING PORTFOLIO THEORY
Ones
and
Threes
Portfolio
of 5
Portfolio
of 10
Portfolio
of 40
Return
1.0% …
1.0% …
1.0% …
1.0% …
1.0%
Risk
3.0% …
3.0% …
1.4% …
1.1% …
0.8%
Ratio
0.3 …
0.3 …
…
0.9 …
1.3
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EXAMPLE OF COMBINING ALPHAS
US Bond Alpha
JPY/USD Alpha
Combined
200%
175%
Information Ratio:
US Bond Alpha
150%
125%
=
0.65
JPY/USD Alpha =
0.55
Combined
0.87
=
100%
75%
50%
25%
0%
-25%
70
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74
76
78
80
82
6
84
86
6
88
90
92
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DIVERSIFIED ALPHA IS BETTER
THAN NONDIVERSIFIED ALPHA
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Traditional
Fixed Income Mandate
Fully Diversified
Pure Alpha
Sources of Value Added: 6
Sources of Value Added: 77
Average correlation: 0.25
Average Correlation: 0.04
IR per slice: 0.35
IR per slice: 0.35
Implied IR: 0.56
Implied IR: 1.40
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SCALABILITY OF OVERLAY
Scaling an Information Ratio of 1.0
20%
18%
GTAA
Alpha/Return
16%
14%
12%
10%
8%
6%
4%
Enhanced
Cash Active
Bonds
2%
Active
Equity
Hedge Funds
0%
0%
2%
4%
6%
8%
10%
12%
14%
16%
Tracking Error/Volatility
Source: Bridgewater analysis
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18%
20%
OPTIMAL ALPHA REQUIRES
 Positive
 No
Expected Return
systematic risk
 High
sample size
 Risk
targeting ability
 Integration
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with benchmarks
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Hedge Funds: Alpha or Beta?
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HEDGE FUND CORRELATIONS
Average Managers’ Correlations Within Style
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Hedge Fund Groups
by Strategy
Average Correlation of
Return Above Cash
for Funds within Group
Convertible Arbitrage
Dedicated Short Bias
Emerging Markets
Equity Market Neutral
Event Driven
Fixed Income Arbitrage
Global Macro
Long-Short Equity
Managed Futures
Multi-Strategy
60%
51%
59%
42%
66%
52%
47%
63%
57%
53%
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BETAS IN HEDGE FUNDS
Fixed Income Arbitrage
BW Simple Fixed Income Arbitrage Replication
Fixed Income Arbitrage Strategy Hedge Funds
Rolling 6-Month Excess Returns
15%
10%
5%
Correlation:
77%
0%
-5%
-10%
-15%
'93
'94
'95
'96
'97
'98
'99
'00
'01
'02
'03
'04
'01
'02
'03
'04
Cumulative Excess Return
75%
50%
25%
0%
-25%
'93
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'94
'95
'96
'97
12
'98
'99
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BETAS IN HEDGE FUNDS
Merger Arbitrage
Merger Arbitrage Strategy Hedge Funds
15%
10%
5%
BW Simple Merger Arbitrage Replication
Rolling 6-Month Excess Returns
Correlation:
56%
0%
-5%
-10%
-15%
'93
'94
'95
'96
'97
'98
'99
'00
'01
'02
'03
'04
'01
'02
'03
'04
Cumulative Excess Return
80%
60%
40%
20%
0%
-20%
'93
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'94
'95
'96
'97
13
'98
'99
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BETAS IN HEDGE FUNDS
Emerging Markets
Emerging Markets Strategy Hedge Funds
BW Emerging Markets Strategy Replication
Rolling 6-Month Excess Returns
50%
Correlation:
79%
30%
10%
-10%
-30%
-50%
'93
'94
'95
'96
'97
'98
'99
'00
'01
'02
'03
'04
Cumulative Excess Return
75%
50%
25%
0%
-25%
-50%
'93
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'94
'95
'96
'97
14
'98
'99
14
'00
'01
'02
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'03
'04
BETAS IN HEDGE FUNDS
Managed Futures
Managed Futures Strategy Hedge Funds
BW Simple Managed Futures Strategy Replication
Rolling 6-Month Excess Returns
50%
Correlation since Jan. 1999:
90%
30%
10%
-10%
-30%
-50%
'93
'94
'95
'96
'98
'99
'00
'01
'02
'03
'04
'01
'02
'03
'04
Cumulative Excess Return
125%
100%
75%
50%
25%
0%
-25%
-50%
'93
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'97
'94
'95
'96
'97
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'98
'99
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APPLYING HEDGE FUNDS
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
Are you getting alpha or beta?

Diversify.

Allocate based on alpha/beta targets.

Overlay HF alpha onto optimal beta.
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MONEY MIGRATION
% of Total AUM (Scaled to 5% TE)
Alpha Overlay
Traditional
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1991
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1992
1993
1994
1995
1996
1997
17
1998
17
1999
2000
2001
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2005
MANAGER MIGRATION

Traditional Fund Mangers Who Switched to HF/Alpha Overlay:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
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Jack Meyer
Brian Posner
Michael DiCarlo
Leon Cooperman
Jeffrey Vinik
Rob Donahue
Greg Jackson
David Glancy
Peter Trapp
Warren Lammert
Nicholas Tiller
Chirstopher Zepf
Dan Szemis
Gary Schlarbaum
Harvard Mgt
Warburg Pincus
John Hancock
Goldman
Fidelity
Solomon Brothers
Oakmark Global
Fidelity
Needham
Janus
Fidelity
Fidelity
Merrill Lynch
Morgan Stanley
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Alpha Overlay
Hygrove Partners
DFS Advisors HF
Omega HF
Vinik Asset Mgmt
Own fund
Blum Capital HF
Own fund
Own fund
Granite Point Capital
Hedge fund
Hedge fund
Hedge fund
Schlarbaum Capital
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Global Macro Funds
• Global macro managers take views on a variety of asset classes (e.g., equities, fixed income,
currencies, commodities, etc.) by studying cause-effect relationships between macro economic
variables and assessing how these are being (mis)priced in markets
• Example of macro economic variables: growth, inflation, central bank policy (e.g., intervention),
political events, balance of payments, capital flows
• The implementation of these views takes many different shapes and forms:
• Systematic – cause-effect are studied and programmed into a logical code
• Discretionary – views are typically implemented through directional and concentrated bets
Process Example:
Global Macro
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Outright
Duration
Relative
Country
Duration
(diffs)
D World
Interest Rates
D Relative
Interest Rates
Developed
Bonds
vs.
Emerging
Market
Debt
D EMD Credit
Spreads
Nominal
vs.
InflationIndexed
Bonds
D Breakeven
Inflation Rates
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Relative
Country
Inflation
Indexed
Bonds
D Relative
Real Yields
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Currency
Outright
Equity
Relative
Country &
Sector
Equity
Commodities
Exposure
D Currency
Forwards
D World
Equity Prices
D Relative
Equity Prices
D Commodity
Prices
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Fixed Income Arbitrage
• Fixed Income Arbitrage managers are trying to capture spreads and positive carry in various
forms, from simple strategies to more complex ones:
 Emerging market credit spread - the managers try to time exposure to EMD spreads
(duration hedged spread against US treasury), with bias towards being long the spread
 Mortgage-backed securities - similar to EMD spreads, the managers are biased
towards capturing the spread between MBS/ABS/CMBS and US treasuries by applying
models for calculating prepayment risk (the option embedded in MBS). They tend to
take the exposure in the less liquid/traded CMO trenches were they think mis-pricing of
the prepayment option exists
 Volatility trading - the managers take views on volatility and skews and are biased
towards being short options and collecting the difference between implied and actual
volatility
 Carry/yield curve trades - try to capture positive carry (the difference between cash
and longer-term rates) and implement views on the shape of the yield curve applying
interest-rate models. These views are applied to the short-end of the curve (Euro$) and
the long-end (Bonds)
 Currency - managers take some active views on currencies, primarily based on
interest rate diffs between countries
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