August 14, 2014
August 14, 2014
Long-standing clients of our firm know that we are intrinsically skeptical of those who promise market-beating results on the basis of their ability to time the market and/or identify macroeconomic trends that will provide superior returns. Such boasts are commonplace in the world of hedge funds, of course, and are used to justify unusually high manager fee structures.
From the hedge fund customer’s perspective, and all else being equal, high fees simply reduce returns and the active trading common to hedge funds generates heavy taxation of any profits. Gravity is gravity, and it’s not surprising to us that most academic studies confirm that hedge fund returns, over the long run, have been mostly disappointing. Some economic periods are not average, though, and in light of the 57 percent decline in the S&P 500 Index during the financial crisis and its 173% perecnt rise from the nadir on March 9, 2009 (*), investors understandably yearn for access to a hedge fund star with the Midas touch.
We are reminded of perhaps the best known star manager in recent years, John Paulson, who reportedly took home, in personal compensation, a figure close to $4 billion in 2008 by correctly predicting that lower quality (“subprime”) mortgage securities would plunge in value. How profitable would it have been to hitch a ride with Mr. Paulson not merely after he was identified as a star, but even before what was once called “the greatest trade in the history of the world”?
Mr. Paulson’s flagship fund, the Paulson Advantage Fund, was a primary beneficiary of his prognostication. The Advantage Fund recorded phenomenal returns in 2007 and 2008 of 51.74 percent and 6.28 percent, respectively, against the S&P 500 index returns of 5.49 percent and -37.00 percent over the same two years. Post 2008, however, the Advantage Fund hasn’t done very well. A dollar invested at the beginning of 2009 would have been worth 84 cents at the end of 2013. Meanwhile, a dollar invested in the S&P 500 index over the same time period would have been worth $2.28, or 170 percent more than a dollar invested in the Advantage Fund. Somewhat shockingly, the Advantage Fund has even underperformed the S&P 500 index over the last 10 years – a period that includes Mr. Paulson’s stellar years of performance. (See chart.)
The results are a reminder that with big bets, timing is everything. A swift move into the fund before the financial crisis, followed by an exit near the onset of recovery, would have resulted in remarkable results. In contrast, those who took a chance on Mr. Paulson after his marvelous play on subprime mortgages have drastically underperformed the S&P 500 Index.
The results are also a reminder that while wealth is a privilege and opens many doors, it does not by any means guarantee better investment returns. Only the most affluent people have the opportunity to invest their money with Mr. Paulson, due to the high minimum investment requirements, but few will be sad to have missed the party.
(*) J.P. Morgan’s Guide to Markets as of December 31, 2013