Hedge fund stars plummet to earth

Three years ago, John Paulson bet the house against housing and got incredible results. When the real estate bubble popped, the hitherto-unknown hedge fund manager pocketed a tidy $15 billion. But 2011 is proving to be a humbling year for the newly minted titan, whose past triumphs were detailed in the book “The Greatest Trade Ever” (Crown Business, 2009). After perfectly calling the nation's economic catastrophe, Mr. Paulson turned around and bet prematurely on its recovery. As a result, his biggest fund has lost nearly 50% of its value this year, largely courtesy of a massively bad bet on Bank of America Corp. Two other hedge fund heroes of the dark years of the financial crisis also have hit the rocks recently. Bill Ackman, who smelled the rot in subprime mortgages well before the herd and wagered accordingly, was down 16% this year heading into October — due in part to a hefty loss on Citigroup Inc. Similarly, Bruce Berkowitz's stellar record of snapping up quality stocks at depressed prices has taken a serious blow: His portfolio has been hammered by huge positions in BofA and American International Group Inc., where he ranks second only to the federal government on the list of largest shareholders. Now these prominent money managers must persuade their disappointed clients that they are more than one-trick ponies.

'A LOT OF SKILL INVOLVED'

“There's a lot of skill involved in becoming a successful hedge fund manager, but there's also a fair amount of luck when it comes to finding the right investment at just the right time,” said Jonathan Satovsky, chief executive of Satovsky Asset Management LLC, a firm that invests client money in hedge funds. “And, of course, the luck part of the equation can turn on you quickly.” The 10% market rally last month, and the recent jump in financial stocks, suggests that time hasn't yet run out for beaten-down fund managers trying to salvage this year. But increasingly, it appears their investors are losing patience. A survey of 150 hedge fund investors by Barclays Capital last month found that 35% of them planned to exit funds that had performed below expectations, and another 20% were considering doing so. “Everyone has a much shorter-term perspective,” said one unidentified hedge fund manager. “Investors who were in it for one or two years are now in for one or two quarters; people who were in for one or two quarters are now in for one or two hours.” Irwin Latner, a partner at law firm Herrick Feinstein, said he doesn't expect the $2 trillion hedge fund industry to shrink, but he does expect money to be shuffled out of large complexes such as Mr. Paulson's Paulson & Co. Inc. which has $35 billion under management, and Mr. Ackman's Pershing Square Capital Management LP, which has about $10 billion, and into smaller, more nimble funds. “You're already starting to see people seed new funds or invest in the smaller hedge funds, because it's a lot easier for those to outperform the market,” Mr. Latner said. But many investors still remember Mr. Paulson's long-term record. Despite a rocky 2011, his biggest fund boasted an annualized return of 25% over the five-year period through Sept. 30, according to a person familiar with the fund. Still, Mr. Paulson's stunning loss on BofA's shares shows how difficult it is even for the best-regarded market maven to stay ahead of the herd consistently.

BIG GAINS AT FIRST

Mr. Paulson bought 168 million shares of BofA at the height of the financial crisis in early 2009, paying about $2.2 billion, according to Bloomberg data. He doubled his money over the next 12 months but then held on too long. Although he unloaded some of his stake as the shares sank back to crisis-era prices, Mr. Paulson still had about 60 million shares this summer, when BofA's stock tumbled another 20%, according to Bloomberg data. Mr. Berkowitz's timing was even worse. His fund, Fairholme Capital Management LLC, started building its BofA stake last year, when the stock was near its post-crisis peak. What's more, he kept adding to his position — now nearly 100 million shares. Both Mr. Paulson and Mr. Berkowitz have had other dogs in their portfolios. The former this spring took a big position in News Corp., which subsequently was engulfed in a phone-hacking scandal that called into question the controlling Murdoch family's leadership. The shares went nowhere. Another big Paulson holding, China-based tree-farm owner Sino-Forest Corp., collapsed in an accounting scandal over the summer, handing the greatest trader ever an estimated $720 million loss. As for Mr. Ackman, he amped up his bet on Citi in May, figuring investors would forget about the bank's near-collapse three years ago and instead begin to appreciate it for its global reach. Unfortunately, in the weeks after he boosted his stake to a cool $1 billion, Citi's stock fell by a third. As Mr. Ackman awaits a turnaround at the bank, he is rolling the dice on two of the nation's most troubled sectors: housing and consumer goods. He has snapped up 15% of the shares in Fortune Brands Home & Security Inc., a maker of faucets and cabinets, and a 26% stake in retailer J.C. Penney Co. Inc. Both have posted modest gains this year.

STAYING THE COURSE

Despite their setbacks, all three hedge fund managers insist they have no intention of altering their strategies. For Mr. Ackman, it generally means making big investments in just a handful of companies—power stakes that he insists force management teams to take his turnaround advice, and in the process help attract new investors and make his positions worth more. “We don't mind if others join the ride,” he told investors recently. Now, if they only would. Aaron Elstein is a senior reporter at sister publication Crain's New York Business.