Sometimes it seems the hedge fund industry is the victim of its own hype. Whenever there’s a downturn, the scary truth gets whispered: There are no geniuses out there.
John Paulson’s dreadful performance this year serves as a reminder of this maxim. Paulson’s fame is based on a brilliant short bet on the housing market that overnight turned his firm into one of the biggest — and made him an instant billionaire.
As has happened often in the hedge fund world, the extraordinary profits made during a single year were based on market anomalies that don’t last forever. Yes, Paulson timed the recovery right and bet correctly on the rise of gold. But he appears to have succumbed to the hubris that affects so many, as he refused to change his views earlier this year when the markets went against him.
Paulson is hardly alone in 2011, as most hedge funds have had a tough year even as money has continued to flow into the industry. The bigger the industry gets, the more it seems to correlate with the overall market. Take long/short equity. Over the past year the AR U.S. Equity Index has correlated 97 percent with the Standard & Poor’s 500 index.
In recent years investors flocked to big funds like Paulson’s while starving smaller funds of capital. There are advantages to size but disadvantages as well. So maybe it’s time to take a look at the little guys. In our “Funds to Watch” feature, starting on page 49, we highlight five that are promising, including Hildene Capital Management, the subject of our Niche profile last month. Hildene has found a classic route to hedge fund riches: an esoteric strategy no one else has discovered.
Such strategies are great to find, but they do have a time limit. The trick is making the leap to a broader stage, a move that has bedeviled many a great manager. Think about convertible arbitrage. During the 1990s pioneers like Harlan Korenvaes of HBK Capital Management and Kenneth Griffin of Citadel minted money in that area. Then the field was overrun by a slew of hedge funds, and it became harder to profit. As the difficulties that have beset both HBK and Citadel remind us, figuring out the next step is the tough part.
