Ray Dalio’s ‘All-Weather’ fund goes cold

Bridgewater’s Ray Dalio

FORTUNE — The hedge fund that claims it will never have an off year just had one in 2013.

Bridgewater Associates’ All-Weather fund dropped 3.9% last year. This has come at a time when the sky for many investors has been quite clear. The stock market rose nearly 30% in 2013. It rained on the bond market. The Barclays Capital Aggregate Bond Index fell just over 2%. Still, All-Weather did worse.

Of course, all hedge funds essentially claim that they will make money no matter what. That’s what the “hedge” in their title is supposed to indicate. But Bridgewater Associates with the All-Weather fund has been explicit about it.

Bridgewater, which is run by Ray Dalio, has pitched the fund aggressively to pension funds around the country. Dalio even made a video explaining why the fund will go up even if stocks or bonds go down. All-Weather has attracted $70 billion in assets. Bridgewater doesn’t say how much of that is from pension funds, vs. other investors.

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The fund, which launched in 1996, is based on a concept that Dalio pioneered called risk parity. Others have launched similar funds. Essentially, Dalio thinks most investors get diversity wrong. They put some of their money in stocks and some of their money in bonds, perhaps 60-40, and call it day.

Dalio says that’s not how we should go about it. What investors really need to do, he argues, is diversify their risk. Bonds are traditionally much less risky than stocks. A 60-40, or even 50-50, split isn’t going to do that. You need to hold a whole bunch of bonds, at least compared to how much money you put in stocks. In fact, the only way to get as much exposure to bonds, relative to stocks, as risk parity proscribes, is to borrow money against your portfolio and buy more bonds.

What results is basically a leveraged bond portfolio. So it’s not really that big of a surprise that the All-Weather fund would tumble in a year when bonds did poorly. Yet, decades of falling interest rates and rising bond prices have made the fund look invincible. Even including 2013’s poor returns, All-Weather is up 12.4% over the past five years.

With interest rates rising, and the expectation that they will continue to rise for a while, this appears to be the end of the run for All-Weather, along with the belief that the fund had the ability to perennially defy the market. At the New York Times’ Dealbook conference in November, I asked Dalio whether he thought it was a good idea to continue to pitch All-Weather to pension funds at at time when interest rates are likely to continue to rise. In fact, Dalio predicted that himself.

In response to my question, though, Dalio said Bridgewater had back-tested All-Weather and found that it would have done fine in, say, the late 1970s, and other periods of rising interest rates. But here’s the flaw. In the 1970s, interest rates were much higher than they are now. So any money a fund would have lost on falling bond prices would have been more than offset by high interest rates.

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That’s not going to happen now. Interest rates on 10-year U.S. Treasuries are around 3%. That’s not nearly enough of a cushion for the damage a drop in prices will do to a bond portfolio, particularly a leveraged one.

It’s the second year in a row that Dalio, who has had a stellar track record, has put up disappointing returns. In 2012, Bridgewater’s flagship Pure Alpha fund was up just 0.8%. The fund did better in 2013, up 5.25%, but it delivered far lower returns compared to those who simply put money into the market.

The sunny days for the All-Weather fund, and Dalio in general, may be over.

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