A man monitors stock prices at a securities trading firm in South Korea. (Photographer: Jean Chung/Bloomberg News)  

For Hedge Fund Stars, Being Right In 2008 Proved To Be A Curse

(Bloomberg Businessweek) -- It was the spring of 2008, and David Einhorn gave the most memorable speech of his career. At a conference in Manhattan, the hedge fund manager took to the stage at the standing-room-only concert hall and delivered a scathing attack on Lehman Brothers. The U.S. investment bank, he said, hadn’t disclosed before that year billions of dollars of assets tied to loans and had incorrectly valued some its mortgage-related assets.

Lehman filed for bankruptcy four months after Einhorn’s presentation, cementing his reputation as a money manager with a sharp eye for spotting corporate troubles. Around the same time, another New York hedge fund manager, John Paulson, was minting a fortune by betting that more U.S. subprime mortgage borrowers would fail to make their payments. Across the Atlantic in London, a firm run by a lower-profile hedge fund manager, Alan Howard, had prepared for a financial crisis by cutting risk and buying investment contracts that would profit from market volatility.

The global financial crisis that unfolded in 2008 was terrible for the hedge fund industry—on average, it lost a record 19 percent. Strangely, though, it added to the mystique of the hedge fund manager. Einhorn, Paulson, and Howard were part of a small cohort who showed foresight at a time when other investors were racing toward the cliff. And that’s exactly what hedge funds are supposed to do. While regular mutual funds largely ride the market’s ups and downs, hedge funds charge high fees (traditionally 2 percent a year, plus 20 percent of profit) on the promise that their managers can outsmart the faulty wisdom of crowds. But in the decade since the crisis, Einhorn, Paulson, and Howard have all, to varying degrees, lost their cachet, and their businesses are mere shadows of their former selves.

They’re hardly alone. The $3 trillion hedge fund industry, less glamorous than it was during its heyday, is crowded with managers struggling to justify their costs. The problem with a business based on geniuses who can spot trends is that few remain geniuses forever. “Regression to the mean is a very powerful force in the universe,” says University of Pennsylvania psychologist Philip Tetlock, who studies the track records of professional forecasters. “It’s harder for hedge funds to sustain high performance in the long term, especially when you have a lot of smart people second-guessing each other.” Einhorn, Paulson, and Howard declined to comment through their spokespeople.

Each unhappy hedge fund is unhappy in its own way. Einhorn’s tale is one of a classic value investor, the dogged researcher who digs into companies hoping to find overlooked gems or, sometimes, overhyped trash. By 2008, he was already renowned as a bold stockpicker and a gadfly. He’d spent much of the 2000s taking to task a lender called Allied Capital over its accounting. He also shorted the stock—that is, bet on its price falling. He’d ultimately be proven right on Allied, as he was on Lehman, which he also shorted. Even so, 2008 proved a hard year for Einhorn. His Greenlight Capital lost about 23 percent as the rest of the portfolio was dragged down in the historic market slide. Then again, an investor in a sensible S&P 500 index fund lost 37 percent.

Now Einhorn is struggling in a bull market. Greenlight has tumbled 25 percent this year. Einhorn has been wrong-footed on nearly all of his top 40 holdings. He has bet on a crash in technology stocks, including Netflix and Amazon.com, that hasn’t happened. Meanwhile, he’s been long on Brighthouse Financial, which has tumbled 31 percent this year; General Motors, down 17 percent; and German drug and chemical giant Bayer, which has slumped about 31 percent. He’s also bet on gold, which has lost 8 percent.

Einhorn told investors in July that it’s been a frustrating environment for value investors. “Right now the market is telling us we are wrong, wrong, wrong about nearly everything,” he wrote. “And yet, looking forward from today we think this portfolio makes a lot of sense.” Investors pulled about $3 billion from Greenlight in the past two years, leaving it managing about $5.5 billion in assets, less than half the peak of $12 billion three years ago.

Paulson had been an expert on investments related to company mergers before he spotted problems in subprime. His bet, which involved buying insurance against mortgage defaults, earned an amazing $15 billion and catapulted him from obscurity into a Wall Street celebrity and billionaire. While he was criticized for profiting from financial calamity, investors flocked to his namesake hedge fund, where assets ballooned to $38 billion by 2011.

After that victory he got a taste for the big trade—and sought to replicate his success by making more wagers on sweeping economic trends. But Paulson proved too bullish on a U.S. economic recovery soon after the crisis and too bearish about Europe’s sovereign debt turmoil. He thought Greece could default and the euro would likely unravel, but neither happened. Gold, he said, would rise in the face of inflation. After reaching a record high in 2011, it has tumbled. Disappointed with Paulson’s trades, investors pulled billions from his firm, leaving it managing about $8.7 billion—most of it belonging to him. These days, Paulson is overhauling his hedge fund in a bid to return to his roots of betting on mergers.

Howard didn’t shoot to fame the way Paulson did; betting on volatility isn’t as attention-getting as foreseeing the collapse of the American housing market. Still, the fund he co-founded produced double-digit returns in 2007, 2008, and 2009, enough to catch the notice of pension funds and other large investors seeking a bulwark against losses. His firm, Brevan Howard Asset Management, swelled to $40 billion by 2013.

Howard is what’s known as a macro manager. Such traders make wagers on the direction of economies by trading everything from the yen to oil. Howard made his name with bets on interest rates. He sidestepped the bond market rout in 1994 and the collapse of hedge fund Long-Term Capital Management four years later. But lately he’s faced the problems that have beset macro funds in the years after the financial crisis. Central banks have taken extraordinary steps to keep markets calm, which has fueled a multiyear stock rally while creating fewer opportunities for macro traders who actually thrive on volatility.

Policymakers have also telegraphed changes in interest rates, making it difficult for Howard and others to bet on them. While Howard and some macro managers have staged something of a comeback this year as volatility returned to markets—Brevan’s main fund is up 10.2 percent, and Howard posted a staggering 44 percent profit in the first five months in a fund he solely manages—Brevan’s assets have shrunk to $7.5 billion.

Hedge fund managers, who pride themselves on their ability to make money in any market, have delivered returns in the past decade that are less than half those of the prior 10 years. They’ve also attracted less than half as much money from investors. Managers have blamed everything from the rise of exchange-traded funds to increased algorithmic trading. In the past year, veterans such as John Griffin and Leon Cooperman have called it quits. And since the start of 2016, investors have pulled a net $62 billion from hedge funds, the most since the aftermath of the financial crisis, according to Hedge Fund Research Inc.

Europe’s biggest asset manager, Amundi SA, said this month it would stop investing in hedge funds to focus on mutual funds and other low-cost alternatives. Meanwhile, some hedge fund strategies are being sold to the mass market, says William Goetzmann, a finance professor at Yale University. For example, factor investing, which groups stocks by common traits such as price volatility and momentum, is being used in ETFs. “What was considered the secret sauce of hedge funds, retail investors can now get cheaply,” says Goetzmann.

Hedge funds have made an average 3 percent in the first eight months of this year, according to data compiled by Bloomberg, while U.S. stocks have risen 9.9 percent. The industry has some cause for optimism: This year saw a hedge fund startup raise $8 billion, the most ever, while another raised $4 billion. Even so, hedge funds aren’t the stars of Wall Street anymore. That distinction goes to private equity funds, which have raised a record amount of money last year. Some of them have increased their fees to boot. —With assistance from Melissa Karsh, Nishant Kumar, and Katherine Burton

To contact the editor responsible for this story: Pat Regnier at pregnier3@bloomberg.net

©2018 Bloomberg L.P.