Blasphemy? Quantitative Approaches Don’t Always Work Best

Ray Dalio’s Bridgewater Associates hedge fund, Pure Alpha II, is up 25% in year that hasn’t been kind to competitors. How did he do it?  Hint: it wasn’t through a purely quantitative approach.

Hedge fund manager Ray Dalio is a rare breed in financial investing. Dalio is known as a “macro” investor, or someone who takes a “big picture” approach to investing as opposed to math whiz “quants” who rely on quantitative/numerical techniques.

The July 25, 2011 issue of New Yorker, highlights Dalio’s investment methods as he looks for hidden profit opportunities; “(Dalio) spends most of his time trying to figure out how economic and financial events fit together in a coherent framework. His constant goal (is to) understand how the economic machine works.”

Dalio isn’t concerned with the nuts and bolts of companies. He doesn’t want to scrub the bowels of the machine to see how it works. And he shuns frequency based probability techniques used by financial quants to estimate whether stocks will move up or down in penny increments.

While other hedge funds and investment banks control risks with sophisticated Value at Risk (VAR) models and use of derivatives, Dalio suggests that studying the big picture is a better approach. “Risky things are not in themselves risky if you understand them and control them,” he says. Instead of statistical distributions, it appears Dalio is more focused on what he calls the “probability of knowing”.  He never places all his eggs in one basket, especially because he understands that a complex and global world can shift course in a moment’s notice.

This is not to say, however, that Dalio doesn’t use analytical techniques. Of course, Dalio crunches the numbers and uses computers for much of his work. But he’s not driven by making money with techniques such as high frequency trading, where super computers trade liquid instruments at near light speed. Instead, his algorithmic trading models are written with his investment philosophy of components and relationships in mind, and help supplement decision making for broad and big bets.

Dalio is doing much more than guesswork here, but it’s a different kind of analysis based on a rules based framework codified in thirty years of investment experience. “It’s the commitment to systematic analysis and investment (within the boundaries of his mental framework) that makes the difference,” he says.

The contrast between Dalio’s approach and those of data driven quants couldn’t be clearer. Quants model investment decisions based on math and use computers to move volumes of liquid securities thus making money on tight spreads. Dalio seeks to understand “larger underlying forces”, interrelationships and historical context. His main advantages appear to be a “top down” rather than “bottom up” approach to investing and the pursuit of a longer time line for decision making.

In 2008 during the worst of the Great Recession, Dalio was up 9.5%, in 2010 the fund was up 45%, and Dalio’s $122B fund is up 25% this year (2011) based on macro bets for Treasuries, Japanese Yen and Gold.

It may be blasphemy, but for one investor, a macro “big picture” approach is proving much more profitable than one that’s (normal distribution) probability driven.

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