While in college, a friend of mine would routinely go to Vegas and play blackjack. He was an excellent player and always seemed to come out ahead. But one time I asked him, “Are you addicted to gambling?”
He said, “It’s not an addiction if you win.” He had a good point — he would have been an excellent hedge fund manager.
Despite all the talk of “risk management,” such investors are often bet-the-ranch operators. This is inevitable if you want to create alpha – i.e., achieve market-beating returns.
And over the past few years, the best hedge fund manager has been John Paulson. In 2006-2007, he made a massive bet by shorting subprime mortgages. The result was the biggest gain in hedge fund history: $20 billion.
Then he made a massive bet on distressed financials as well as gold. Again, he made billions.
The problem, of course, is that when massive bets go bad, the results can be downright awful. And this has been the case for Paulson. In the last couple months, his flagship fund, Advantage Plus, is off a terrible 20%. And the loss was 13% in the first two weeks of June!
What’s going on? First of all, Paulson continues to be a big bull on the banks, such as Citigroup (NYSE:C) and Bank of America (NYSE:BAC), and they have been horrible performers. Some of the drivers include the “soft patch” in the U.S. economy and stringent federal regulations, which will likely crimp margins.
Next, Paulson made a substantial investment in Sino-Forest, a Chinese-based forest company. Unfortunately, a vocal short-seller published a scathing report on the firm and the stock price plunged more than 80%. Paulson’s loss may be more than $700 million.
To recover, Paulson will likely need to continue making big bets. And if he has essentially lost his hot hand, then he will dig his hole deeper and deeper, which will lead to investor redemptions.
This has been the predicament of many legendary hedge fund managers, like Julian Robertson, Michael Steinhardt and George Soros. It’s a relentless tough business.
On the other hand, Paulson will probably remain a multi-billionaire, so it’s pretty hard to shed tears for him or his wealthy investors.
Tom Taulli’s latest book is “All About Short Selling” and he has an upcoming book called “All About Commodities.” You can find him at Twitter account @ttaulli. He does not own a position in any of the stocks named here.