Sunday, July 1, 2012

The Rise and Fall of Hedge Fund Titans?

Svea Herbst-Bayliss of Reuters reports, John Paulson's returns falter again; investors fret:

Billionaire trader John Paulson has told his wealthy investors that he has learned from his mistakes of 2011, which produced enormous losses for his closely watched hedge fund.

The founder and manager of Paulson & Co, who made his fortune and fame by betting against the subprime mortgage market, went so far as to tell investors in January that last year's big losses, including a 50 percent decline in his popular Advantage Plus fund, were an "aberration."

But as the months tick on, many investors are still waiting to see the dramatic turnaround Paulson has vowed to deliver.

Halfway through 2012, Advantage Plus is down again, losing 10 percent through May. Another big portfolio that bets on gold - once a bright spot for Paulson - was also in the red. In both cases, he blamed losses in gold stocks for the declines.

This has taken a huge bite out of the firm's assets, which have fallen to $22 billion from $38 billion early last year, according to investors. Redemptions were substantial, but poor performance accounted for the bulk of the drop, they said.

While Paulson still has loyal clients, some U.S. public pension funds and Wall Street firms that are invested with him have expressed their growing unease.

There are few signs of a quick comeback for the 56-year-old trader, who fumbled in 2012 by missing out on a big first-quarter rally in U.S. financial stocks. Last year, a Paulson fund got pounded by being too bullish on banks. He cut some of those losing positions - most notably by exiting Bank of America Corp in late 2011, just before the rebound.

Adding more pressure are some rare defections as two of his top lieutenants - Robert Lacoursiere, a former partner, and banking analyst James Fotheringham - left in March to start their own fund, Petrarca Capital.

"It is fair to say that he is having a difficult year," said Steve Yoakum, executive director of the $30 billion Missouri Public Employee Retirement System, which is invested with him.

New Mexico, which stuck by Paulson through last year's growing losses, pulled its $40 million investment in the first quarter.

"From time to time, I do check on John Paulson to see whether we did the right thing," said Joelle Mevi, the state's chief investment officer. "And I see that we did."

Mevi, who oversees $11.9 billion in public pension money, said New Mexico had decided to cash out in part because of concerns that the manager's fund had become too large and could not easily get in and out of positions.

At least one Wall Street bank that raked in big fees selling access to Paulson's funds over the years is souring on him. The brokerage arm of Morgan Stanley put Paulson on a "watch list" early in the second quarter, instructing clients to avoid putting new money with him.

To be sure, Merrill Lynch, UBS AG and other banks whose brokerage arms also offer access to Paulson funds have not taken similar steps.

And some of Paulson's other portfolios were doing better and posted gains in the first five months of 2012.

Charles Krusen, chief executive officer of Krusen Capital Management, says he thinks Paulson has taken key steps to reposition the portfolio by hedging better and pulling back some of his positions.

"Going into the second half of 2012, he is well-positioned," Krusen said.

A spokesman for Paulson declined to comment for this story.


Paulson has admitted to his investors that in 2011 he was overly optimistic about the speed of the U.S. recovery and underestimated the magnitude of Europe's debt crisis. He has called last year's performance "unacceptable" and said he was committed to delivering a "superior investment performance" in the future.

Some analysts who study the $2 trillion hedge fund industry say Paulson may have miscalculated again this year.

Known for his patient, or some might say stubborn, views, Paulson is sticking with gold stocks, saying they are undervalued compared with the price of the metal.

He told investors these stocks had helped performance from late May through early June, but for the year to date, two of his big holdings have not performed well. AngloGold Ashanti is down nearly 20 percent on the New York Stock Exchange, while Gold Fields Ltd's ADRs have fallen nearly 17 percent.

Another criticism is that Paulson is late trying to capitalize on bets that the crisis in the euro zone will mean hard times for the continent's banks and financial institutions.

Paulson has told investors that his team has spent a lot of time thinking about Europe and possible calamities that could occur there, including a Greek payment default.

If Greece does default and exits the common currency, he said, European banks would be hit extremely hard.

"He seems anxious to be shorting Europe, but he needs an event to succeed, such as a bank failure, but the European Central Bank and European Union officials have so far obviated that," said Peter Rup, CEO and chief investment officer at Artemis Wealth Advisors, which is not invested with Paulson.

As they tweak the portfolio, Paulson and his team are spending a lot of time trying to persuade jittery investors to stick with him and newcomers to put money with him.

One New York adviser to wealthy clients recently expressed surprise at how much time Paulson, one of the industry's busiest managers, had spent explaining his views on the world and investing to him. The adviser requested anonymity because his employer forbids him to speak to the media.

Paulson, who mostly avoids the society pages and big-name events that some of his rivals seek out, has also been attending more industry gatherings.

In May, for the first time, he presented his "best ideas" at the Ira Sohn Investment Conference, a popular charity event attended by a number of well-known managers. But the idea Paulson presented was anything but new: He listed AngloGold Ashanti, a long-term holding, as one of his favorite picks.

He previously let his 2007 returns speak for him. That year, largely on the strength of the subprime trade, his credit fund surged 591 percent, and the Advantage Plus fund rose 163 percent.


There are signs that the pressure to deliver may be getting to the normally soft-spoken manager, who has long said that he and his partners put up more than half of his firm's capital.

Earlier this year, he shouted impatiently on a conference call, urging management at Hartford Financial Services Group Inc, another big holding, to consider splitting up the company.

Investors have only a few chances to pull their money out of his various funds every year. To do so by the end of June, they would have had to notify Paulson by mid-May, according to several smaller investors who said they had asked for their money back.

Investors have said Paulson has signaled that second-quarter redemptions will add up to the usual few percent of past quarters.

But if the numbers do not show improvement soon, industry analysts worry that confidence may weaken further, especially if other big clients like state pension funds begin to bolt.

"We don't have a formal watch list, but he is being watched more closely," Missouri's Yoakum said. "And we are certainly much more critical than we have been in the past."

John Paulson's very bad year was also featured on the cover of Bloomberg Businessweek. DealBook blog covered some of the main points, Paulson Talks Returns, Regret and Retirement in New Profile:

Appearing on the forthcoming cover of Bloomberg Businessweek is a close-up of the hedge fund titan John A. Paulson. Plastered over his face is a sticky note with the words “The Big Loser.”

It is unlikely that the hedge fund manager, who cooperated for the profile, is happy with that depiction. But after a bloody year in which one of his biggest funds lost more than 52 percent, and with 2012 shaping up to be another period of poor performance, those words are on the lips of more than a few investors.

Mr. Paulson offers readers a sense of regret about the loss, but tries to put it in perspective.

“We had built up a great track record — in 18 years, we only had two down years, one of which was last year,” Paulson told Businessweek. “That drawdown was disappointing, but you can’t think about the past. You have to think about the future.”

The piece walks through the last few years of Mr. Paulson’s investing career, much of which is largely known in an environment where almost nothing is too small to report about the billionaire investor. It talks about his background, schooling, career as an investment banker and then an average hedge fund manager. It quickly gets to the period when everything changed – when Mr. Paulson bet against the subprime mortgage market, and made billions.

Asked about how it felt to go from a nobody to an investing all star, the magazine reports:

Paulson may have a rare analytical gift, but he is either unwilling or incapable of turning it on himself. When asked what it was like to go from being an unknown investor to a semi-celebrity, he pauses for what feels like a long time. He then starts banging his hands loudly on the table in front of him and lets out a huge sigh. “How would you answer that?” he says, turning to the two men next to him.

“I don’t think you’ve changed or the firm’s changed,” his PR consultant says hesitantly.

Paulson pauses again. “I’m not sure how the visibility felt,” he says, “but achieving our investment goals for ourselves and our investors felt great.”

Mr. Paulson also spends at least some time chiding investors, like the New Mexico Public Employees Retirement Association, for fleeing from his fund. Some investors have been split on that point: whether to flee the bad performance of the last year or so, or stick with it, thinking, ‘How much worse can it get?’

“If you’re going to come in and then leave, come in and leave, I don’t think you’ll reap the benefits of investing with us,” Paulson told Businessweek. “Investors that do the best, and have done the best, are those that stay and compound at above-average rates over the long term.”

Mr. Paulson’s persnickety attitude is not just reserved for investors who fled the bad performance. Asked how he felt about the Occupy Wall Street movement taking aim at his excessive wealth, he told Bloomberg this:

“I think it’s somewhat misguided,” he says, growing agitated. “We pay a lot of taxes, especially living in New York — there’s an almost 13 percent city and state tax rate. … Most jurisdictions would want to have successful companies like ours located there. I’m sure if we wanted to go to Singapore, they’d roll out the red carpet to attract us.” He goes on, “We choose to stay here and then, you know, get yelled at. I think that’s misdirecting their anger at the wrong place.”

So why not throw in the towel? He’s got money, more than most could spend in a lifetime, and has accrued a stable of plush mansions and toys to rival a Saudi prince. Here’s what he told the magazine:

He’s ruled out the possibility of a Paulson & Co. initial public offering any time soon — “I don’t think hedge funds belong as public companies” — but he says he’d be “very happy” to see the firm continue after he retires. Which won’t be anytime soon, by the way.

“I’m still relatively young, you know, being 56,” he says. “If you look at Soros — he’s 81, I think. Buffett, he’s 81. … How old is Icahn?” Even though he could easily stop working, he can’t imagine it. “Some people like playing chess, some like backgammon. This is like a game, and playing games is fun,” he says, dispensing with any niceties about serving his clients. “It’s more fun when you win.”

I've never met John Paulson. I have met other hedge fund titans like Ray Dalio and discussed deflation and deleveraging with him long before Bridgewater jumped on that bandwagon.

But even though I've never met Paulson, I can tell you that I always thought his fame and status was grossly inflated by the media, allowing him to gather billions in assets. Now that he's struggling, his publicized woes will work against him.

Look, Paulson wasn't alone to profit big time off the 2008 financial crisis. One of my favorite hedge fund managers, Andrew Lahde, returned 866% betting on the subprime collapse and then had the foresight to walk away and say goodbye.

Paulson decided to stick around. His life, his prerogative, I don't fault any man who wants to continue earning a living doing what he loves best.

But I will tell you Paulson's rise and fall is nothing new. I've seen it many times before. Typically, hedge funds have a great track record, or an incredible year, consultants and brokers start spreading the word to institutional investors and in no time assets under management explode up.

That's when your antennas should go up and you need to start thinking of pulling out. Whenever I see assets explode up, from $5 billion to $40 billion, I pay very close attention because it usually spells trouble ahead.

That's exactly what happened with Paulson. He was riding the coattails of his outsized returns, assets under management mushroomed and returns subsequently faltered. Seen this so many times and yet the institutional herd keeps piling onto yesterday's winners like moths to a flames.

It's all part of human nature. Nobody wants to hold losers in their portfolio. Only winners. But in the game of hedge fund investing, the easiest thing is to write a big fat cheque to some well known hedge fund. Much harder to know when to pull the plug and when to allocate more to a struggling manager.

It pains me to watch institutional dummies repeating the same mistakes over and over again, getting eaten alive by hedge fund fees. In that comment, I wrote the following:

I get nervous when I see hedge funds all over the media. I prefer the guys who keep their heads down and deliver alpha. I am very impressed with Ken Griffin and Citadel whose flagships recently cleared their high-water marks, allowing them to start collecting performance fees after getting clobbered in 2008. Coming back strongly from a significant loss tells me a lot about a hedge fund.

In my humble opinion, Ken Griffin is the best hedge fund manager alive today, even better than legends like Soros, Dalio, Tudor Jones, Kovner and many others I covered when I tracked Q1 holdings of top funds.

When Citadel got clobbered during the financial crisis, I went on record and stated pension funds should 'double down' their allocations. Most dummies redeemed but the smart ones stuck with them and added more. They understood exactly why Citadel lost so much (market for corps and convertibles froze at the height of the crisis).

Should you always add more when a hedge fund or external manager gets clobbered? Of course not. Most of the time you should be pulling the plug way before disaster strikes. You need to look at the portfolio, assets under management, people, process, and risk management and make a quick decision.

This isn't easy but if you don't, you'll end up holding on and listening to a bunch a sorry ass excuses as to why you need to be patient. And no matter who he is, I would never accept any hedge fund manager 'chiding' me for redeeming from their fund. That's beyond insulting, but in an era where hedge fund superstars are glorified, this is what routinely happens.

Been there, done that, it's a bunch of BS. The media loves glorifying hedge fund managers but the bottom line is all these 'superstars' are only as good as their last trade. Institutional investors should stop glorifying these managers too and start grilling them hard.

And then there are the charlatans, crooks and tax evaders. Bryan Burrough of the NYT reports, A Trader Who Swerved, and Crashed, covering Guy Lawson's new book on the 2005 collapse of the Bayou Group hedge fund, an engrossing tale of the rise of Samuel Israel III, a cocaine-snorting crook who started his firm in the basement of his Westchester County home.

Diane Enriques of the NYT reports on how clients of J. Ezra Merkin, a prominent Wall Street hedge fund manager who invested his clients’ money in Bernard L. Madoff’s epic Ponzi scheme, will recover more than $400 million under a civil settlement negotiated by the New York State attorney general’s office.

Azam Ahmed of Dealbook reports the Securities and Exchange Commission filed civil charges against Philip A. Falcone and his hedge fund, Harbinger Capital Partners, claiming that the investor improperly took a loan from his firm and gave preferential treatment to a large investor.

I can write my own book on all the silliness I've witnessed investing in Malakia Capital Management. To be sure, there are excellent hedge fund managers, but the bulk of the industry is full of self-absorbed egotistical 'malakes' (wankers) who are peddling leveraged beta to incompetent and clueless institutional managers getting fed horse shit from equally incompetent and clueless investment consultants who have never invested a dime in hedge funds.

Most of these consultants have never even conducted a rigorous investment, operational and risk due diligence on any manager. And then we are shocked to hear that fast times in Pensionland are delivering mediocre results, contributing to the pathetic state of state pension funds.

Finally, Reuters reports, EU watchdog plans curbs on hedge fund pay:

European regulators published draft rules on Thursday to crack down on excessive bonuses for managers of hedge funds, a sector politicians have blamed for worsening euro zone debt problems.

Policymakers have already clamped down on bankers' bonuses, a move that has proved popular in the wider world where most people's incomes are becoming ever-more squeezed.

The prospect of big bonuses can also encourage employees at financial firms to take excessive risks, regulators say.

The European Securities and Markets Authority (ESMA) said on Thursday such curbs must be extended to managers of alternative investment funds, including hedge funds and private equity and real estate funds.

The rules could have a huge effect on hedge fund managers - the bulk of whose pay is from performance fees - and will apply from the end of this year to senior managers, risk takers and employees whose total package puts them in the same bracket as top management.

Open for consultation until September, the rules bolster a law the EU has approved to force all alternative investment fund managers to obtain authorisation and undergo direct supervision from July next year.

The law was brought in after politicians accused hedge funds of taking bets on falls in banking shares at the height of the 2007-09 global financial crisis, and more recently on drops in euro zone debt prices.

ESMA Chairman Steven Maijoor said the remuneration curbs were in line with those imposed on bankers' pay.

"This consistency will help strengthen the protection of investors and avoid the creation of adverse incentives for those managing alternative investment funds," he said in a statement.

As with banks, the underlying idea is that only a portion of a bonus can be paid upfront in cash, with the rest deferred or cancelled if the performance rewarded turns out to be illusory.

The draft ESMA guidelines say that before the deferred part of a bonus is paid, employee performance must be reassessed so the sum is properly aligned to "risks and errors" and that 40-60 percent of a bonus should be deferred over several years.

The guidelines also state at least half of any variable pay, both deferred and upfront, should consist of equity-linked instruments related to the fund.

Hedge fund managers are typically paid a relatively small fixed salary and then earn most of their money from lucrative performance fees charged on the assets they manage for clients.

These fees have turned dozens of managers into some of the wealthiest in the financial industry, and attracted scores of traders to leave banks and try their luck at hedge funds, where pay has been under less public scrutiny.

Many hedge fund bosses hold much of their wealth in their own funds. One industry source said this helped ensure their interests were aligned with those of investors because, unlike bankers, they lose money if their funds perform poorly.

Remuneration, whether fixed or variable, includes cash, shares, options, pension contributions, discounts, fringe benefits and special allowances for cars and mobile phones.

A so-called retention bonus will be viewed as variable pay and only allowed if it does not encourage excessive risk taking.

It's about time we start looking into remuneration of hedge funds, private equity funds and real estate funds. Renuneration in finance is already ridiculous, and for the few at the top, it's downright obscene, creating huge distortions in the society we live in.

Take it from me, no matter how good they are, most of these guys (and a few gals) who make up the 'financial elite' are grossly over-compensated. This is the real tragedy of modern day financial capitalism and left unchecked, it will lead to social anarchy.

Once again, listen to renowned academic David Harvey who rightly asks if it is time to look beyond capitalism towards a new social order. Even Nobel-prize winning economist, Joseph Stiglitz, is warning that under-regulated and over-powerful banks weaken the global economy and lead to higher inequality. Below, embedded a recent Democracy Now interview with Joe Stiglitz, warning on the rise of inequality.

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