Santangel's Review

Commentary

A General Theory of Hedge Fund Investing

This must be the week for finding nuggets of wisdom embedded in the most unexpected places. Today’s nugget comes from a Bloomberg article on John Paulson. The article quoted an unnamed investor who redeemed from Paulson’s fund. The investor explained his theory on investing in hedge funds:

“One institutional investor, whose firm withdrew its money from Paulson’s funds in 2011, says that most hedge funds follow a familiar developmental pattern. During the first stage, funds often improve quickly, but they’re also small and therefore difficult for large institutions to invest in. The second stage is when the fund’s managers are working hard and have shown some success; that’s when the upward curve is steepest, and the most astute investors get in. Stage three, which the institutional investor called“cresting,” usually comes after the fund has become quite large and performance starts to drop off.

By stage four, fund managers are wealthy and acquiring trophies like baseball teams, says the investor, who asked not to be identified because it might affect his company’s relationships with other funds. At stages three and four, performance tends to deteriorate, though not always, the investor says. In deciding to pull its money, the investor says his firm believed Paulson & Co. had arrived at stage three or four.”

We’d argue that there is likely a stage 5 as well. This could also be called the “death of equities” stage referring to the famous BusinessWeek magazine cover which marked not the end of equities, but ironically the end of a bear market. When investors all head for the exit of a hedge fund after a run of bad performance, that is when they may put up some of their best returns.