Posts tagged ‘John Paulson’
Betting on Green: Not All Performance is Equal
Not all performance is created equally. Now is the time of year where professional money managers jockey for position before year-end, either with the intent of locking in above-average performance or throwing up a Hail Mary pass in hopes of gaining lost performance ground. Typically, top performing managers are lauded for their eye-popping returns and shrewd investing acumen, when in fact, often these managers have been playing a game of roulette in which a risky, low probability strategy of betting on “green zero” has paid off (a winner about 2.6% of the time).
With tens of thousands hedge fund managers, mutual fund managers, and investment advisors self-reporting their results, even if the performance is accurate, the “Law of Large Numbers” dictates a small percentage will outperform. In other words, short-term luck can often trump long-term skill in the investment world, so investors really need to take a look under the covers to better understand the composition of the results.
Here are some factors contributing to performance distortions and misunderstandings:
Leverage: Adding leverage to your investment strategy is a lot like switching from a bicycle to a motorcycle. The new vehicle may get you to your destination faster, but the risks are lot higher than riding a bike, including death. The same principles apply to investing. A leveraged portfolio may be a fun ride when prices appreciate, but the agony on the downside can be equally painful in reverse. Often, many managers obscure the amount of leverage, and point to absolute returns rather than risk-adjusted returns, which rightfully account for the underlying volatility of the security or investment. To better measure investment performance on an apples-to-apples basis, risk-adjusted ratios such as Sharpe ratios and Treynor ratios should be used.
Concentration/Style Drift: Similarly to playing a game of roulette, putting all your money on black can result in a very handsome payout, but the downside can be just as severe. In the late 1990s growth managers benefited tremendously by concentrating their portfolios into technology stocks because prices appreciated virtually unabated. Many value managers succumbed to style drift by abandoning their value investment mandates and chasing performance. Investors should scrutinize the composition of their portfolios to better comprehend the bets managers are making. Excessive concentration or style drift may lead to a rude awakening.
Benchmark Cherry Picking: Buried in the fine print of an investment prospectus or pitchbook, a performance benchmark, which acts like a measuring stick, can usually be found. The non-standardized game of performance reporting is a lot like a beauty contest in which the investment manager can pick ugly competitors to make themselves look better. Typically a manager compares their performance against the worst performing benchmark or index, and if the benchmark performance improves, a manager can again substitute the old benchmark with a newer, uglier one.
Spaghetti Effect: Another misleading marketing strategy used by many investment firms is what I like to call the “Throwing-Spaghetti-Against-the-Wall” technique, which involves throwing as many strategies at investors as it takes and see what sticks. Famed hedge fund manager John Paulson, who made Herculean profits during the collapse of the subprime crisis, used this strategy in hopes of capitalizing on his sudden fame. The results haven’t been pretty over the last few years as his major funds have massively underperformed and assets have collapsed from about $38 billion at the peak to less than an estimated $20 billion now. Paulson has proved that parlaying one successful bet into many spaghetti throwing strategies (Advantage, Advantage Plus, Partners Fund, Enhanced Fund, Credit Opportunities, and Recovery) can lead to billions in gained assets, albeit shrinking.
Window-Dressing: Portfolio managers are notorious for selling their stinkers and buying the darlings at the end of a quarter, just so they can avoid uncomfortable questions from investors. By analyzing a manager’s portfolio turnover (i.e., the average holding period for a position), an investor can gauge how much shuffling is really going on. Generally speaking, managers performing this value-destroying, smoke and mirrors behavior are doing more harm than good due to all the trading costs and frictions.
While periodically reviewing absolute reported returns is important, more critical than that is analyzing the risk-adjusted returns of a portfolio, so apples-to-apples comparisons can be made. Any and all strategies are bound to underperform for periods of time, but in order to make rational investment decisions investors need to truly understand the underlying strategy and philosophy of the manager(s). Without following all these steps, investors will have better luck putting their money on green.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct positions in any Paulson funds or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Paulson Funds: From Ruth’s Chris’s to Denny’s
Investing in hedge funds is similar to eating at a high-priced establishment like Ruth’s Chris’s (RUTH) – not everyone can eat there and the prices are high. In dining terms, John Paulson, President of Paulson & Co. (approximately $34 billion in assets under management), may be considered the managing chef of the upper-crust restaurant. But rather than opening the doors of his funds to an elite few, Paulson is now making his select strategies available to the masses through a much more affordable structure. Or in other words, Paulson is opening an investing version of Denny’s (DENN), in addition to his Ruth’s Chris, so a broader set of investors can buy into his funds at a reasonable price.
Hedge funds typically are reserved for pension funds, endowments, wealthy individuals, or so-called “accredited investors” – individuals earning $200,000 annually, couples earning $300,000, or people with a net worth greater than $1,000,000. By using alternate structures, Paulson will be able to bypass the accredited investor regulatory requirements and reach a more expansive audience.
UCITS Added as a New Item on the Menu
How exactly is Paulson opening his hedge fund strategies to the broader public on a Denny’s menu? He is assembling what is called a “Ucits” structure (Undertakings for Collective Investments in Transferable Securities). These investment vehicles, adopted in 1985, resemble mutual funds and are domiciled in Europe. Although Ucits have been used by relatively few hedge fund managers, Paulson is not the first to institute them (York Capital, Highbridge Capital Management, BlueCrest Capital, and AHL are among the others who have already taken the plunge). According to the Financial Times, Paulson’s Ucits funds will launch later this year. Part of the reason this structure was chosen over others is because the regulations associated with these structures are expected to be less stringent than other onerous regulations currently being discussed by the European Union.
Will the Investing Mouths be Fed?
Should this move by Paulson be surprising? Perhaps Andy Warhol’s quote about everyone being famous for 15 minutes is apropos. Paulson’s $15 billion subprime housing profits in 2007 (read The Greatest Trade Ever) were a handsome reward and now he is attempting to further his wealth position based on this notoriety. Do I blame him? No, not at all, but time will tell if he will be viewed as a one-hit wonder, or whether his subprime bet was only an opening act. More recently, Paulson has been vocal about his seemingly peculiar combination of bullish wagers on gold and California real estate, which he sees rising in price by +20% in 2010 (see Paulson on California home rally). With his optimistic outlook on the U.S. markets and economy, his gold play apparently is riding on the expectation of a future inflation flare up, not another financial meltdown, which was the catalyst that catapulted gold prices higher in late 2008 and throughout 2009.
I’m not sure how many domestic investors will participate in these Ucits investments, however I am eager to see the prospectuses associated with the funds. Like most hedge funds, caution should be used when investing in these types of vehicles, and should only be used as a part of a broadly diversified investment portfolio. For most investors, my guess is the Paulson funds will have an attractive price of entry (i.e., availability), much like a Denny’s restaurant, but the quality and fee structure may be as desirable as a $5.99 greasy steak and pile of gravy-covered mash potatoes.
Read the Entire Financial Times Article on Paulson’s Ucits Launch
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct positions in RUTH, DENN, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Goldman Cheat? Really?
Really? Am I supposed to be surprised that the SEC (Securities and Exchange Commission) has dug up a CDO (Collateralized Debt Obligation) deal with $1 billion in associated Goldman Sachs (GS) losses? The headline number may sound large, but the billion dollars is not much if you consider banks are expected to lose about $3 trillion dollars (according to an International Monetary Fund report) from toxic assets and bad loans related to the financial crisis. Specifically, Goldman is being charged for defrauding investors for not disclosing the fact that John Paulson (see Gutsiest Trade), a now-famous hedge fund manager who made billions by betting against the subprime mortgage market, personally selected underlying securities to be included in a synthetic CDO (a pool of mortgage derivatives rather than a pool of mortgage securities).
Hurray for the SEC, but surely we can come up with more than this after multiple years? More surprising to me is that it took the SEC this long to come up with any dirt in the middle of a massive financial pigpen. What’s more, the estimated $1 billion in investor losses associated with the Goldman deal represents about 0.036% of the global industry loss estimates. These losses are a drop in the bucket. If there is blood on Goldman’s hand, my guess is there’s enough blood on the hands of Wall Street bankers to paint the White House red (two coats). The Financial Times highlighted a study showing Goldman was a relative small-fry among the other banks doing these type of CDO deals. For 2005-2008, Goldman did a little more than 5% of the total $100+ billion in similar deals, earning them an unimpressive ninth place finish among its peers. As a matter of fact, Paulson also hocked CDO garbage selections to other banks like Deutsche Bank, Bear Stearns, and Credit Suisse. The disclosure made in those deals will no doubt play a role in determining Goldman’s ultimate culpability.
Context, with regard to the fees earned by Goldman, is important too. Goldman earned less than 8/100th of 1% of their $20 billion in pretax profits from the Abacus deal. Not to mention, unless other charges pile up, Goldman’s roughly $850 billion in assets, $170 billion in cash and liquid securities, and $71 billion in equity should buttress them in any future litigation. These particular SEC charges feel more like the government trying to convict Goldman on a technicality – like the government did with Al Capone on tax evasion charges. At the end of the day, the evidence will be presented and the courts will determine if fraud indeed occurred. If so, there will be consequences.
Demonize Goldman?
How bad can Goldman really be, especially considering their deep philanthropic roots (the firm donated $500 million for small business assistance), and CEO Lloyd Blankfein was kind enough to let us know he is doing “God’s work,” by providing Goldman’s rich menu of banking services to its clients.
Certainly, if Goldman broke securities laws, then there should be hell to pay and heads should roll. But if Goldman was really trying to defraud investors in this particular structured deal (called Abacus 2007-ACI), then why would they invest alongside the investors (Goldman claims to have lost $90 milllion in this particular deal)? I suppose the case could be made that Goldman only invested for superficial reasons because the fees garnered from structuring the deals perhaps outweighed any potential losses incurred by investing the firm’s own capital in these deals. Seems like a stretch if you contemplate the $90 million in losses overwhelmed the $15 million in fees earned by Goldman to structure the deal.
Maybe this will be the beginning of the debauchery flood gates opening in the banking industry, but let’s not fully jump on the Goldman Scarlet Letter bandwagon just quite yet. Politics may be playing a role too. The Volcker rule was conveniently introduced right after Senator Scott Brown’s Senate victory in Massachusetts, and political coincidence has reared its head again in light of the financial regulatory reform fury swelling up in Washington.
Waiting for More teeth
There is a difference between intelligent opportunism and blatant cheating. There is also a difference between immorally playing a game within the rules versus immorally breaking laws. Those participants breaking the law should be adequately punished, but before jumping to conclusions, let’s make sure we first gather all the facts. While the relatively minute Abacus deal may be very surprising to some, given the trillions in global losses caused by toxic assets, I am not. Surely the SEC can dig up something with more teeth, but until then I will be more surprised by Jesse Jame’s cheating on Sandra Bullock (with Michelle “Bombshell” McGee) than by Goldman Sachs’s alleged cheating in CDO disclosure.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct positions in GS, DB, Bear Stearns (JPM), and CSGN.VX/CS.N or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
John Paulson and the “Gutsiest” Trade Ever
Although the pain and suffering of the 2008-09 financial crisis has been well documented and new books are continually coming out in droves, less covered are the winners who made a bonanza by predicting the collapse of the real estate and credit markets. Prizewinning Wall Street Journal reporter Gregory Zuckerman decided to record the fortunes made by hedge fund manager John Paulson in his book The Greatest Trade Ever (The Behind-the-Scenes story of How John Paulson Defied Wall Street and Made Financial History).
Paulson’s Cartoonish Cut
Zuckerman puts Paulson’s massive gains into perspective:
“Paulson’s winnings were so enormous they seemed unreal, even cartoonish. His firm, Paulson & Co., made $15 billion in 2007, a figure that topped the gross domestic products of Bolivia, Honduras, and Paraguay…Paulson’s personal cut was nearly $4 billion…more than the earnings of J.K. Rowling, Oprah Winfrey, and Tiger Woods put together.”
As impressive as those gains were, Paulson added another $5 billion into his firm’s coffers and $2 billion into his personal wallet over 2008 and early 2009.
There are many ways to skin a cat, and there are countless strategies used by the thousands of hedge fund managers looking to hit the jackpot like Paulson. John Paulson primarily made his multi-billion fortune thanks to his CDS positions (Credit Default Swaps), the same product that led to massive multi-billion bailouts and government support for various financial institutions.
Bigger Gamble than Perception
One surprising aspect I discovered from reading the book was the uncertainty surrounding Paulson’s negative real estate trade. Here’s how Zuckerman described the conviction level of John Paulson and Paolo Pelligrini (colleague) as it related to their CDS positions on subprime CDO (Collateralized Debt Obligation) debt:
“In truth, Paulson and Pellegrini still were unsure if their growing trade would ever pan out. They thought the CDOs and other risky mortgage debt would become worthless, Paulson says. ‘But we still didn’t know.’”
Often the trades that cause you to sweat the most tend to be the most profitable, and in this case, apparently the same principle held.
Disingenuous Dramatic License
Before Paulson made his billions, Zuckerman uses a little dramatic license in the book to characterize Paulson as a small fry manager, “Paulson now managed $1.5 billion, a figure that sounded like a lot to friends outside the business. But the firm was dwarfed by its many rivals.” Zuckerman goes on to call Paulson’s hedge fund “small potatoes.” I don’t have the industry statistics at my fingertips, but I’ll go out on a limb and make an educated guess that a $1.5 billion hedge fund has significantly more assets than the vast majority of hedge fund peers. Under the 2 and 20 model, I’m guessing the management fee alone of $30 million could cover Paulson’s food and shelter expenses. Before he struck the payload, the book also references the $100 million of his personal wealth he invested with the firm. I think John Paulson was doing just fine before he executed the “greatest trade.”
What Drove the Greatest Trade
Hind sight is always 20/20, but looking back, there was ample evidence of the real estate bubble forming. Fortunately for Paulson, he got the timing generally right too. Here are some of the factors leading to the great trade:
- CDO Leverage in Subprime: By the end of 2006, the subprime loan market was relatively large at around $1.2 trillion (representing around 10% of the overall mortgage market). But thanks to the introduction of CDOs, there were more than $5 trillion of risky investments created from all the risky subprime loans.
- Liars & Ninjas: “Liar Loans” loans based on stated income (using the honor system) and “ninja loans” (no income, no job, no assets) gained popularity and prevalence, which just led to more defaults and foreclosures in the mid-2000s.
- No Down Payments: What’s more, by 2005, 24% of all mortgages were completed with no down payment, up from approximately 3% in 2001. The percentage of first-time home buyers with no down payment was even higher at 43%.
Overall, I give kudos to Gregory Zuckerman, who spent more than 50 hours with John Paulson, for bringing something so abstract and homogenous (a skeptical real estate trade) to life. Zuckerman does a superb job of adding spice to the Paulson story by introducing other narratives and characters, even if the story lines don’t blend together perfectly. After reading The Greatest Trade Ever I came away with a new found respect for Paulson’s multi-billion dollar gutsy trade. Now, Paulson has reloaded his gun and is targeting the U.S. dollar. If Paulson’s short dollar and long gold position works out, I’ll keep an eye out for his next book…The Greatest Trad-er Ever.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including VNQ), but at time of publishing had no direct positions in companies mentioned. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
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