Paulson Takes it on the Chin

John Paulson is probably the most celebrated hedge fund manager in the world. For those of you who have been living under a rock for the past few years, he rose to prominence after one of his funds returned just under 600% in 2007 after taking long positions in CDOs which tracked MBS backed by sub-prime mortgages. This trade has been the inspiration for two books: Gregory Zuckerman's "The Greatest Trade Ever" and Michael Lewis' "The Big Short", and the basis for a record-setting settlement in an SEC case filed against Goldman Sachs.

Although he was not the only one to see through the mess of subprime mortgage securitization, he certainly profited the most handsomely. He followed up this bet with short positions in select financial firms in 2008 and reversed this position in time to catch the epic rally in bank stocks from the March 2009 lows.

Lately however, he has been giving his profits back. His largest fund is down 46% year to date (here), representing approximately $9 billion in losses. In response, Paulson is reportedly scaling back risk, which will make it awfully effectively impossible for him to reclaim his high water. Presumably massive redemption requests are in the mail.

Personally, I have always thought that Paulson was a considerably over-hyped. Before his subprime bet, he was an also-ran in the merger arbitrage space. Yes, he made one fantastic call but if he was a mediocre merger-arb manager, how does one call make him a savant? His bets on a vigorous economic recovery have made it quite clear that he (and his analysts) do not understand what a post credit-bubble economy looks like. The fact that he held somewhere around $1B of Sino-Forest stock speaks volumes to his due diligence practices.

Paulson's investment attributes aside though, he may be suffering from a very common problem in the hedge fund world - size begetting poor performance. FTAlphaville recently posted an article summarizing a comprehensive report of hedge fund returns (here):

Using data from 1980 to 2008, the authors calculated the compound annual return for the average hedge fund to be 13.8%... The dollar-weighted number is a much better proxy for actual profits earned by investors in hedge funds. For the whole period 1980-2008 that number is 6.1% as opposed to the 13.8% headline number.

It is a common refrain that the best returns are earned when a fund is in its infancy, but it is nice to see someone actually run the numbers to confirm it. Combine that fact with the astronomical growth in Paulson & Co's assets under management (and a manager with dubious global macro credentials), and the -50% annualized return becomes much less of a surprise.

I would not be surprised if Paulson & Co shuts up shop sometime in 2012.