In this interview with Value Investing with Legends, Ray Dalio explains how his approach to investing is to focus on return streams rather than asset classes. He defines a return stream as “a decision rule that would produce return streams.” He then goes on to explain that he can construct a well-diversified, uncorrelated mix of alphas by separating the alpha and the beta of an investment. This allows him to create portfolios with a higher ratio of return to risk. Here’s an excerpt from the interview:
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Dalio: I never really thought about going into the hedge fund business as much as I thought about return streams. And what I would do is I’d always write down a decision rule and I would test the decision rule and I created a bunch of decision rules that would produce return streams.
So in other words, a return stream, I mean, you have an asset class has a return stream. And an alpha has a return stream. In other words, a decision rule has a return stream.
So I would make these decision rules into return streams. And because I was also dealing in futures which then evolved into other derivatives, I could overlay that on anything, and of course when hedging I did that.
So I thought about putting together portfolios of return streams. And so long or short, didn’t matter, just it’s a return stream, just a good return stream.
And then I thought about alphas and betas and what the world was doing back then was they put the alpha and the beta in the same asset class.
So in other words, they would say if you’re a stock manager, stock equities, that you would then have your alpha in equities. And then I said, why do that? I can have my alpha in whatever arrangements I have. So I can construct a well diversified, uncorrelated mix of alphas that’s going to give me a higher ratio of return to risk.
Because I could create a diversified alpha portfolio and put it on whatever benchmark you want, which I could then buy synthetically, I could buy S&P futures or whatever we want and I could overlay it. So why not separate the alpha and the beta and just create the best portfolios of alphas and the best portfolios of betas?
And that’s what I did. And then I was lucky, I had some smart clients. This wasn’t done. Who said, okay, well that sounds interesting and makes sense. And that’s what I did.
You can listen to the entire interview here:
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Article by The Acquirer’s Multiple
