The top hedge fund managers may have lengthy streaks of success over time, but that success usually ends eventually
When one of the top hedge fund managers goes into a performance slump, media and investor reactions often leave us with an odd feeling. They make us wonder, “Why does this surprise you?”
The media and the investors they quote seem to treat a hedge fund manager’s slump as a temporary departure from a predictable career path—like a series of bombs by an Oscar-winning film star, or an unreadable experimental novel by your favourite author.
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The top hedge fund managers: a cautionary tale
For example, John Paulson pole-vaulted to the top of the hedge-fund heap in 2008, with a superbly timed bet against the subprime mortgages that were financing the real-estate boom. When the boom collapsed, that single trade earned $15 billion for Mr. Paulson’s investors and $4 billion for him personally. To top it off, he was able to defer taxes on his portion of the profit for nearly a decade, using a U.S. tax provision available at that time to hedge-fund managers.
The success of Mr. Paulson’s 2008 trade-of-a-lifetime brought him many new investors. The total assets under Paulson’s management rose to $38 billion by 2011. By then, though, his winning streak had lost momentum. He had some wins and some losses, but the latter predominated. At one time, he owned 14% of Sino-Forest, a Canadian firm that we advised staying out of. Sino-Forest went into bankruptcy in 2012. Canadian regulators later said its executives had engaged in fraud.
In 2014, Mr. Paulson revealed his fondness for Valeant Pharmaceuticals. This was already a high-flying Canadian speculation, and we had already advised steering clear of it. The stock was then trading at $140 a share, and Mr. Paulson predicted it would hit $250. This was in part a self-fulfilling prophecy, since the prediction got a great deal of media attention.
The stock briefly got above $250 in July 2015. From there, things deteriorated.
Valeant fell below $100 in October 2015. Mr. Paulson met with 40 of his investors and told them he still liked Valeant and similar drug stocks. The following April, Valeant fell below $36. To reassure investors, Mr. Paulson sent them a letter that announced changes in his firm’s risk management. For instance, he would limit his exposure to any one industry group to 35% of assets under management.
However, when a stock drops in price, it automatically cuts the proportion that its value represents in the portfolios of its shareholders. Soon after issuing the letter, Mr. Paulson bought more Valeant. But Valeant was just one of several disappointments in his portfolio.
Not that we mean any disrespect to Mr. Paulson. He’s still one of the top performers in hedge-fund history. I’m using his story to make a point about the game, rather than any one player. Troubles like these happen inevitably in any area of aggressive investing, and that includes hedge funds.
Stick with real businesses, not speculative investments like hedge funds
To succeed as a Successful Investor, you have to understand the difference between a conventional business on the one hand, and a speculative trading venture (like a hedge fund) on the other.
A conventional business can prosper if it creates value for its customers and/or clients, and if its insiders/managers have the financing and persistence to stick with it. That way, they gain knowledge and reputation as time passes. They build a body of knowledge by attracting a core of dedicated employees who learn on the job how to work together and pursue the company’s goals. This enables the company to compete in its business and to continue creating value during the inevitable setbacks.
In contrast, speculative trading aims to profit by making side bets on fluctuations in the economy. These side bets may revolve around short-term price changes in high-risk stocks, or relationships between financial and economic statistics, and so on. However, chance plays a large role in the outcome of any one of these bets. You rarely learn anything from the outcomes, other than that randomness is a major factor in them, and that random events tend to occur in bunches.
That’s why it so often happens that a trader guesses right for a few months or years on a stock like, say, Valeant, then suddenly starts guessing wrong.
Aggressive investments are subject to more volatility and random outcomes than conventional, conservative investments, so guesswork plays a bigger role. A string of wrong guesses can quickly lead to disaster.
Early in their careers, many speculative traders carry out a string of winning trades that hint at a near-superhuman sense of market timing. However, signs of such a gift rarely last long. Instead, good luck eventually turns into bad luck, and a winning streak morphs into a devastating string of losses.
The top hedge fund managers know when to take a break. They get out with some of their fortune intact. This fortune includes what’s left of the initial winnings, but is mostly comprised of the 20%-of-profit bonus fees that hedge-fund investors pay in winning years.
Outside investors get in late, so they miss out on those initial winnings. But they still pay the 20%-of-profit bonus fees in the profitable years (which are not refundable in years of losses). Outsiders may still make money from hedge funds run by the top hedge fund manager and similar trading ventures, of course. But their odds of winning are grim to say the least.
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