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Why Hedge Funds Tripped in a Volatile Year

Date: Tuesday, January 3, 2012
Author: Steve Eder, The Wall Street Journal

Many of the hedge-fund managers who came into 2011 riding a wave of momentum ended the year scratching their heads and nursing losses, whipsawed by markets that seemed to punish them month after month.

Take billionaire hedge-fund titan John Paulson, arguably the industry's biggest star and one of the wealthiest people in the world after making billions of dollars in 2007 with bearish bets on subprime mortgages.

Mr. Paulson began 2011 on a high note, having personally scored more than $5 billion in profits in 2010, and was poised to make more money on big bets on gold and a speedy economic recovery. But by the end of 2011, not only had Mr. Paulson's home on the Upper East Side in Manhattan been a target of Wall Street protesters, but the investing guru also saw his trades backfire, causing one of his biggest funds to lose about half of its value.

The rise and fall of Mr. Paulson and his firm, Paulson & Co., offers a window into what was a frustrating year for many hedge-fund managers, including some of the industry's most-storied.

In 2011, hedge funds on average lost 5%, according to an estimate by Hedge Fund Research Inc., lagging behind the Standard & Poor's 500-stock index, which gained 2.1% on a total-return basis. The net result was that hedge-fund performance, for the third straight year, lagged behind stock-market returns.

The culprit behind the disappointing numbers, many people in the industry say, were the wild market swings, especially in stocks. The economic crisis in Europe fueled the uncertainty, and was often amplified by domestic events, such as S&P's downgrade of the U.S.'s triple-A credit rating.

As the uncertainty caused stock markets to plummet in August and September, many managers raced to take down their investments, causing many to miss out on October's comeback, one of the best months for stocks in decades. Nervous managers, already bitten by months ofvolatility, saw markets move sideways for much of November and December.

"Managers generally got whipsawed in their exposures," said Paul Zummo, the co-head of J.P. Morgan Asset Management's hedge fund of funds group. "They cut down the net exposures, which from a risk-management standpoint was probably prudent. But when things calmed down, they didn't participate as much."

Associated Press

'Occupy Wall Street' protesters gathered at John Paulson's building in October.

The weak numbers and behind-the-curve performance numbers yield troubling optics for institutional investors, who have been eager of late to put money into hedge funds in hopes of bolstering returns.

During the first quarter, hedge-fund industry assets not only surpassed their pre-crisis peak from early 2008, but also topped $2 trillion for the first time, according to HFR data. Industry assets peaked at $2.04 trillion at the end of the second quarter, before tumbling in the third quarter amid market losses. Net investments continued to flow into the industry, but slowed in the third quarter.

Despite the slowdown, Stu Hendel, head of global prime brokerage for Bank of America Merrill Lynch, said he remains optimistic about industry growth because many funds were successful in "muting the volatility and preserving capital."

"This year will separate some of the winners from the losers and it will winnow down the number of hedge funds," Mr. Hendel said of 2011. "But I do think the industry is poised for growth, probably in another six months."

Adding to investors' jitters has been a toughening regulatory climate. The Securities and Exchange Commission announced in December charges stemming from a data- and technology-driven initiative to track managers who consistently report results that appear too good to be true. The screening process is built to analyze data in a way that helps the agency focus its investigations.

"They are just trying to be smarter about what they do, recognizing that if they are not able to catch someone engaged in fraud, it is generally viewed as a failure of the agency," said Jay Gould, head of the investment-funds practice at Pillsbury Winthrop Shaw Pittman LLP in San Francisco.

Insider trading remained a central topic in the hedge-fund industry in 2011.

Former hedge-fund titan Raj Rajaratnam in December began serving an 11-year prison sentence stemming from his May conviction on insider-trading charges, the longest term ever imposed in an insider case. He is appealing.

Prosecutors have called Mr. Rajaratnam, who founded Galleon Group, "the modern face of insider trading." His conviction was the highest profile in a wide-ranging and years-long probe into insider trading.

As managers look ahead to 2012, many are bracing for what could be a year that is almost as puzzling as 2011, because many of the same problems and uncertainties remain.

Joe Omansky, managing partner of Trusted Insight, a social marketplace for institutional investors, said the lack of policy and regulatory movement in 2011 means performance is likely to remain much the same in 2012. He predicted opportunities will be in "niche, off-radar strategies, and distressed opportunities."

Write to Steve Eder at steve.eder@wsj.com