Paulson’s Big Short

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If a hedge fund manager could short his own stock, John Paulson—the genius of 2007/2008, when his fund soared as others floundered—would surely have done so in 2011. Through the middle of August, one of his two major funds was down 30%—with the decline starting months before the mid-summer turmoil. First, it was a bad bet on Chinese timber company Sino-Forest, which was accused of exaggerating its forestry assets. Then, it was the numerous financial institutions that littered Paulson’s portfolio. Bank of America, Citigroup, Hartford Financial: Paulson had built up substantial holdings in these and more before markets worldwide took a tumble.

Schadenfreude aside, few hedge funds were more popular among institutional investors—endowments, specifically—than Paulson’s. Following his miraculous real estate and gold bets between 2006 and 2010, institutional capital flowed in to the tune of $20 billion. For corporate and public pensions, any contributions included in that total were likely tiny parts of their portfolios, since the average public plan has just 3.6% of its assets with hedge funds, and corporate plans have even less at 2.9%. Endowments, however, have long been fans of this asset class and, on average, currently have 16.5% of their assets with hedge funds—nearly equal to the 20.7% they have in fixed-income. John Paulson was a big benefactor of this affection.

Endowments, of course, will endure. The entire endowment model of investing is predicated on the long term. One fund, no matter how popular, will not bring down an endowment. Perhaps, however, it will cause a shift in endowments’—and other institutional investors’—appetite for large, established hedge fund managers at the expense of all others. Two recent studies have shown that smaller managers in the equity and real estate space tend to outperform their larger peers. It’s very possible that the same trend holds in the hedge fund world, with smaller managers potentially maintaining the ability to be more nimble and focused than larger ones.

A potential big winner if this is the case? Oddly enough, John Paulson. Yes, his flagship funds may soon face serious redemption pressure, but Paulson also controls numerous smaller funds. His $350 million Real Estate Recovery Fund saw large gains last year, and stands to benefit if the sloth-like housing market eventually recovers. The $1 billion Gold Fund is doing just fine. His $3 billion Recovery Fund has some solid bank assets that were picked up at times even more distressed than now. Maybe now—for the hedge fund manager himself, as well as for institutional investors—is the time to go long Paulson.

—Paula Vasan