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

Hold Assets (risk premium) TWO WAYS TO MAKE MONEY Hold Assets (risk premium) Make Bets (timing) Beta Alpha

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 Cost: Cheap Expensive

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

SMARTEST BEST RISK MANAGERS THE WINNERS WILL BE… Make good bets Portfolio theory applied to alpha

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 … 0.7 … 0.9 … 1.3

EXAMPLE OF COMBINING ALPHAS US Bond Alpha JPY/USD Alpha Combined 200% 175% Information Ratio: US Bond Alpha = 0.65 JPY/USD Alpha 0.55 Combined 0.87 150% 125% 100% 75% 50% 25% 0% -25% 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02

DIVERSIFIED ALPHA IS BETTER THAN NONDIVERSIFIED ALPHA Traditional Fixed Income Mandate Fully Diversified Pure Alpha Sources of Value Added: 6 Average correlation: 0.25 IR per slice: 0.35 Implied IR: 0.56 Sources of Value Added: 77 Average Correlation: 0.04 IR per slice: 0.35 Implied IR: 1.40

SCALABILITY OF OVERLAY Scaling an Information Ratio of 1.0 20% 18% GTAA 16% 14% 12% Alpha/Return 10% 8% 6% 4% Enhanced Cash Active Active Hedge Funds 2% Bonds Equity 0% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% Tracking Error/Volatility Source: Bridgewater analysis

OPTIMAL ALPHA REQUIRES Positive Expected Return No systematic risk High sample size Risk targeting ability Integration with benchmarks

Hedge Funds: Alpha or Beta?

HEDGE FUND CORRELATIONS Average Managers’ Correlations Within Style

BETAS IN HEDGE FUNDS Fixed Income Arbitrage Fixed Income Arbitrage Strategy Hedge Funds BW Simple Fixed Income Arbitrage Replication Rolling 6-Month Excess Returns Correlation: 77% Cumulative Excess Return

Rolling 6-Month Excess Returns Cumulative Excess Return BETAS IN HEDGE FUNDS Merger Arbitrage Merger Arbitrage Strategy Hedge Funds BW Simple Merger Arbitrage Replication Rolling 6-Month Excess Returns Correlation: 56% Cumulative Excess Return

Rolling 6-Month Excess Returns Cumulative Excess Return BETAS IN HEDGE FUNDS Emerging Markets Emerging Markets Strategy Hedge Funds BW Emerging Markets Strategy Replication Rolling 6-Month Excess Returns Correlation: 79% Cumulative Excess Return

Rolling 6-Month Excess Returns Cumulative Excess Return BETAS IN HEDGE FUNDS Managed Futures Managed Futures Strategy Hedge Funds BW Simple Managed Futures Strategy Replication Rolling 6-Month Excess Returns Correlation since Jan. 1999: 90% Cumulative Excess Return

APPLYING HEDGE FUNDS Are you getting alpha or beta? Diversify. Allocate based on alpha/beta targets. Overlay HF alpha onto optimal beta.

MONEY MIGRATION

MANAGER MIGRATION Traditional Fund Mangers Who Switched to HF/Alpha Overlay: Jack Meyer Harvard Mgt Alpha Overlay Brian Posner Warburg Pincus Hygrove Partners Michael DiCarlo John Hancock DFS Advisors HF Leon Cooperman Goldman Omega HF Jeffrey Vinik Fidelity Vinik Asset Mgmt Rob Donahue Solomon Brothers Own fund Greg Jackson Oakmark Global Blum Capital HF David Glancy Fidelity Own fund Peter Trapp Needham Own fund Warren Lammert Janus Granite Point Capital Nicholas Tiller Fidelity Hedge fund Chirstopher Zepf Fidelity Hedge fund Dan Szemis Merrill Lynch Hedge fund Gary Schlarbaum Morgan Stanley Schlarbaum Capital

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 D World Interest Rates Outright Duration D Relative Relative Country (diffs) Equity Prices Equity D Currency Forwards Currency Real Yields Inflation Indexed Bonds Country & Sector Commodities Exposure D Commodity Prices Nominal vs. Inflation- Breakeven Inflation Rates EMD Credit Spreads Developed Emerging Market Debt we are able to trade all of these markets and we can trade them in multiple countries throughout the world. Alpha opportunity set larger. Allows many alpha streams that have a low correlation.

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   we are able to trade all of these markets and we can trade them in multiple countries throughout the world. Alpha opportunity set larger. Allows many alpha streams that have a low correlation.