Hedge Funds In Trouble

The Financial Times had a nice piece yesterday about hedge funds and bond funds bleeding money during this slump.  The article focuses specifically on John Paulson (who made $4 billion in the mortgage crash, but is down an astounding 40 percent just this year) and the bond fund PIMCO (which dumped its Treasury portfolio, betting that bond prices would tank and yields would spike once QE2 petered out... and lost a fortune on that bet).  But those are far from the only ones who are struggling.  Philip Falcone's Harbinger is on its third crummy year in a row (after hitting it big shorting subprime), and while Steven Cohen's SAC is doing pretty well, and even David Einhorn's Greenlight is having a bad year.

Now, in part these problems are predictable-- the markets haven't done so hot this year, which is when investment funds tend to struggle most: they thrive on at least somewhat efficient markets, and they do well when they can bet on past patterns repeating themselves.  Any time there's a slump, a high-profile few win big (in this past slump, it was Paulson, Soros and Einhorn; in 1987's stock crash, it was Julian Robertson's Tiger and Tudor, and when the British left the European Exchange Rate Mechanism, Soros made a killing).  I think the problems of a lot of these high-profile funds reflect different factors in each case: PIMCO used to be really good on macro... but in retrospect a lot of that seems to be on the shoulders of Paul McCulley, a managing director there who really understood the bond market in a way that I think even Bill Gross probably doesn't.  Paulson was really a schlub who won big on a single bet; it was a huge bet, but he's shown nothing to prove that he can consistently make money, or even outperform the market, in a variety of economic environments.

For me, what these problems show is that finding a really good money manager is incredibly hard.  Sure, in a given year, Greenlight might do great, or Paulson might do great, or SAC or D.E. Shaw might have a huge year.  But the real test of a great manager is one who can outperform the market year over year.  And, in all honesty, I don't think that more than a handful of the tens of thousands of funds can actually do that.  Sure, Warren Buffett will still give you great returns if you can get money into Berkshire Hathaway... but I think about 95% of that is that Buffett's success feeds on itself at this point-- he gets terms better than anyone else because getting an investment from him inspires confidence by itself; put me in charge of Berkshire, and the terms on these investments instantly get worse, and money-making opportunities disappear (there isn't a single money manager in the world who was going to get the terms Buffett got when he put $5 billion into Goldman in 2008; it was essentially free money for him).  But otherwise, I think the super-charged hedge funds of the last few decades are a relic.  For instance, through the 1970s (when the economy was unusually volatile), Soros returned over 30% in his WORST year.  He lost some money in '81, and in the slump of '87, and some more in the tech bust and in his Russia investments (which I think reflected his desire to be viewed as a "messiah" more than any real faith in Russia's markets in the late '90s.  But it's almost impossible to imagine a manager returning over 30% year over year for a decade straight, even in boom times, let alone volatile ones.

So I think the lesson to take is to be wary-- rich people chasing hedge funds who made big returns in the past is a pretty certain recipe for future disappointment.