DECEMBER 2011                                                                                                               

Follow the Profits not the Performance.


The hedge fund and fund-of-fund industries should be viewed through an analysis of the profits they generate for their shareholders rather than through the simple prism of their performance and track record. However, this exercise at the end of 2011 will not provide investors any comfort for the future.

The fund management business has been brainwashed into following performance. Monthly data points and three-year track records are seen as a prerequisite for investing in any fund. However, 2011 should fundamentally question our ‘performance obsession’ in a way that may alter asset allocation.

The Palindrome lesson.
Earlier this year in July ‘star manager’ George Soros retired from running a publicly available hedge fund. Regulation finally got him where markets could not and he returned external money to his investors; of a $25bn fund he returned $1bn - the remaining money belonged to him and his family which he now continues to run privately. His premature obituaries praised him as one of the greatest managers of all time, an accolade we certainly endorse.

But why? Was his performance really better than everyone else’s? In fact if you look at his numbers you could always find a fund that performed better, however, what was remarkable was that he continued to produce good numbers while keeping his asset growth in check; looking back it seems as though he was counting the dollar gain not the percentage gain.  He deserves his place in the pantheon of money managers for creating wealth for clients and himself.

The Ubiquitous Paulson
Turning to a more recent ‘star manager’ let us look at John Paulson. This manager made one of the greatest trades of recent years, shorting the sub-prime mortgage market in the USA. This ‘greatest trade ever’ made 500%+, an estimated $15bn of profit and $3bn for Paulson himself, turning him into an exalted name in financial circles. It also caused massive inflows of capital to his funds so that as he entered 2011 he had AUM of $40bn. He has subsequently suffered huge losses across a number of his funds, some down as much as 50%. This fall has essentially destroyed all profit from the ‘greatest trade ever’ and if you follow the profits, this star manager has burned up all the value for his clients, yet rides in the firmament for himself. 

Two rather varied tales of following profits rather than performance.

Repercussions
Why is this important to asset allocators as the end of 2011? Why do we need to look at profits rather than performance of hedge funds and fund-of-funds?

Let us consider (in the table below) the performance of hedge funds in 2011 (using HFRX information through to the end of November 2011).









These figures are concerning on many levels, however, particularly so when you realise that hedge funds and fund-of-funds were attracting their peak of investor allocations at the start of 2008. The fund-of-funds industry, for example, has shrunk from an estimated $800 billion to a current figure of approximately half of this, both through performance and redemptions. However, if you follow profits and not performance is it clear that a large number of investors will be sitting on losses from these investments not the gains that the longer and impressive track records would have you believe.

This means that a significant proportion of the hedge funds and fund-of-funds are one drawdown away from joining the ‘Paulson syndrome’ as having a negative wealth effect for clients while at the same time having a decent long term track record; an unpleasant tightrope indeed on which to be balancing. 

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