Post: Ray Dalio’s approach to diversification, currency hedging explained, risks associated with undervalued markets & Saudi Aramco’s Initial Public Offering

Ray Dalio’s approach to diversification, currency hedging explained, risks associated with undervalued markets & Saudi Aramco’s Initial Public Offering

Here is a sample of the questions that were discussed In this week’s PensionCraft live Q&A call with Ramin. If you want to find out the full answers to these questions or ask some for yourself, then you can subscribe to our membership here

Please explain Ray Dalio’s approach to diversification, risk/return ratios, correlation etc as critical concepts to understanding investing. 

I have done a YouTube video Review of Ray Dalio All Weather Portfolio for UK Investors and you can view this here

  • Assume you have a 10% risk and 10% return asset
  • Add another asset, then another, then another, what effect does that have on risk?
  • It depends on the correlation on the correlation of the additional assets with the original asset
  • The benefits of correlation level out rapidly with 60% correlation above about 5 assets
  • The benefits of correlation level out more slowly with 0% correlation
  • You just need 15 to 20 uncorrelated return streams which offer good returns
  • There is no one best investment that can improve on this diversified portfolio approach
  • You improve your risk-return ratio by a factor of five by diversifying
  • The information ratio is return over risk
    • How many units of return do you get per unit of risk?

What you want to avoid is this - two assets where the returns move up and down together (on the left). What you want is on the right, two assets where the movement of one asset is independent of the movements of the other because that dampens down portfolio risk.

That’s why the Scooby Doo tree is so powerful. It lets you see which assets are correlated and which aren’t. Correlated assets sit together in side-by-side branches of the tree.

Uncorrelated assets are from different branches of the tree. Choosing those will make your portfolio better diversified.

Almost any equity fund you choose will be highly correlated with another equity fund. You can’t diversify properly with just equity.

Gold is unreliable as a negatively correlated asset with equity. This shows how the rolling correlation between gold and the S&P 500 varies over time. It's very unstable with gold often having a positive correlation with equity which increases portfolio risk.

Compare this with Treasuries which are much more reliably negatively correlated with equity.

Correlation is one thing and crash protection is another. Gold sometimes falls at the same time as equity. More worrying still, gold sometimes crashes while equity is rallying. A crash hedge shouldn’t crash itself!

But this happens much less frequently with Treasuries and the size of the fall is much smaller.

How is currency hedging actually done and how well does it work? What costs are being incurred by the ETF vs. unhedged versions? Is the hedging mechanism different for bond ETF's?

  • This involves a currency swap which is an agreement to swap one currency for another for some period of time
  • Let’s say you have to hedge Vanguard’s “U.S. Government Bond Index Fund - Hedged Accumulation”
    • Vanguard’s description page is here
    • The ISIN code is IE00BFRTDB69
  • The fund owns $1.6 billion of US Treasuries (£1.2 billion)
  • Let’s say we arrange a 3-month swap
    • We have paid $1.6 billion for our bonds
    • We receive $1.6 billion today for the swap and pay £1.2 billion to our swap counterparty (an investment bank)
    • Our $1.6 billion liability is now a £1.2 billion liability, we no longer have any dollar exposure only sterling exposure.
    • At the end of three months, we pay $1.6 billion and receive £1.2 billion from our swap counterparty
    • We’d then arrange another swap for three months... and roll this over time.
    • Normally the cash flows at the end of the swap are forward rates based on the relative cost of carry (interest rate) in the two currencies (a spot-forward currency swap) so in practice this is more complicated and you have to think about the interest difference between the two currencies.
  • Sometimes the swap isn’t perfect because the size of the fund could expand or shrink so the amount is not hedged exactly, but the currency risk will be dramatically reduced to almost zero
  • The cost of the swap will generally be tiny for developed market equity, a handful of basis points

Based on the Star Capital report that Ramin shared the report suggests that US is overpriced and Singapore, Korea, China and  Russia are undervalued markets. What are the risk returns associated with these undervalued markets?

  • South Korea and Singapore are developed countries but Russia isn’t, so it comes with a higher risk
  • EM risks would include
    • Political instability (e.g. Russian sanctions imposed due to military intervention in Ukraine)
    • Corruption (exists in developed markets too but is less endemic)
    • Sensitivity to commodity prices (oil & gas in the case of Russia)
  • South Korea and Singapore are both dependent on China’s economic well being

Singapore is also heavily dependent on China and more dependent on Hong Kong but there are very few funds that specifically track Singapore which are available to UK investors. For example, see this thread from Citywire (here) which shows that the existing funds don’t have Key Investor Information Documents (KIIDs) so aren’t available for UK investors.

Any thoughts on the Saudi Aramco IPO? Aramco generates mountains of cash; however, so does Gazprom. IPOs are generally a bad time to invest; except the UK-government privatisations which surely this is a bit similar to?

  • An IPO is an Initial Public Offering when a private company issues shares on a stock exchange as a means of raising capital to fund its existing operations or expand those operations
  • Saudi Aramco is a huge state-owned oil and gas producing company based in Saudi Arabia, has a staff of more than 70,000 people. The IPO prospectus is available (here) SAR is the Saudi Arabian Riyal, the revenue for 2018 was $356 billion, net income was $111 billion. Exxon 2018 revenue was $279 billion, net income of $20.8 billion one of the largest companies by revenue and one of the largest by market capitalisation.

  • What is the fair price for a company? Valuation is an art rather than a science. One way to value a company is based on the price to earnings (P/E) ratio
  • If other comparable companies (same sector, same country, same size) exist then they will have a similar price to earnings ratio i.e. if we are valuing an oil company then we’d choose similarly sized oil companies in the same country. Say there are three similar companies which have P/E ratios of 10x 14x and 12x then the new company is probably going to be around 12x (the average). If the company seeking an IPO’s latest earnings are $100 million then the market capitalisation would be 12 x $100 million or $1.2 billion. If a billion shares are being issued the price per share would be $1.20.
  • Aramco was looking for a global stock market float of 5% of its company which it thought would be worth $100 billion because it estimated its own total value is $2 trillion.
    • This is an excerpt from an FT article “A year in which the IPO market sobered up”  here
    • “Crown Prince Mohammed bin Salman, the driving force behind the IPO, had once sought to raise $100bn, from a 5 per cent sale of Saudi Aramco on a global exchange. He was adamant that the company was worth at least $2tn.”
    • “Despite bankers pitching for a role on the listing also telling Saudi authorities this could be achievable, negative investor feedback has forced the kingdom to revise its expectations. It now seeks around $25bn, from a 1.5 per cent sale on Riyadh’s Tadawul exchange, hoping to secure a pared-back $1.7tn valuation by relying heavily on local demand.”
  • There is often a shock when a private company goes public because the “guess” of the true value is usually too optimistic. For example, Uber fell by 30% after its IPO. Pinterest and Lyft have also disappointed.

https://www.ft.com/content/e21a75d0-0d14-11ea-bb52-34c8d9dc6d84

My article “High Returns from Warped Risk” may help explain why IPOs are mispriced and it can be found here


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