Following the sub-prime mortgage meltdown and subsequent credit market contagion, 2007 turned out to be pretty gruesome for banks. And a widespread perception has built up – even within the financial media – that it was also bad for hedge funds.
The reality could hardly be further from this perception. In fact, 2007 was a massive year for many hedge funds – if with a lot of dispersion among the returns of hedge funds overall. Some of the big players made their best returns ever, and many billions in profits.
Of course, there were hedge funds that lost money in 2007. Some went out of business – as happens every year. And managers focused on two strategy areas in particular – structured credit and equity market neutral – were caught in the limelight for the wrong reasons.
Among those who made the wrong calls were two structured credit funds run by Bear Stearns Asset Management and the Yield Alpha fund run by Basis Capital of Australia. There were various financing vehicles such as SIVs managed by hedge fund firms that also ran into difficulty.
In August, it was the turn of equity market neutral funds – such as the Global Alpha strategy run by Goldman Sachs Asset Management – to face unwelcome scrutiny as they were hit by big intra-month losses. Many rebounded quickly. But with a lot of these funds still facing the threat of redemptions, the high-profile media coverage of their difficulties – alongside the high-profile coverage of shutdowns on the credit side – seems to have left a lingering impression that it was a torrid year for hedge funds at large.
It has only been more recently that the media has begun to catch up on the managers that made the right calls in 2007 – and just how amazingly well they did.
Foremost among the big winners in 2007 was Paulson & Co, the New York-based firm headed by John Paulson. Best known since its inception in 1994 for relatively steady and low-volatility returns from merger arbitrage and event-driven strategies, Paulson was arguably first to identify the imminent sub-prime meltdown – putting on trades back in 2006 to short the BBB tranches of mortgage-backed securities.
Paulson could hardly have been more right. During 2007, his firm’s assets ballooned from $7 billion to $28 billion before year-end – into the top 10 hedge fund groups by assets globally – boosted by performance in the region of 500% on his specialist credit strategies.
To put this in context, these are probably the most successful trades in history – producing gains many times those of George Soros when he forced sterling out of the European exchange rate mechanism in the early 1990s.
Not surprisingly, Paulson walked away with an unprecedented set of three awards for top risk-adjusted performance at the annual Absolute Return awards event in New York on December 4, including the highly coveted Management Firm of the Year accolade.
Paulson’s gains were simply stunning. But he was far from being the only manager that did amazingly well on the year. There were many others that also had a great year – and not only on the short sub-prime trade but in other areas too, including Asia and emerging market equities, energy and natural resources, and the dollar. Out of 16 award categories in New York, nine of them were won by funds that had gains of more than 50% for the previous 12 months, and four of them by funds with gains of over 100%.
Fund of the Year was the hitherto little-known Passport Global Strategy, managed by a team headed by John Burbank in San Francisco. With a combination of winning bets on India’s consumer sector, in basic materials and the sub-prime market, the $2.3 billion Passport strategy had produced a terrific 12-month gain of more than 240%.
Strong gains were not only made by top managers in the US during 2007. At a recent charity breakfast in London, I moderated a session involving Man Group’s AHL unit, the world’s biggest managed futures fund; Brevan Howard, the biggest macro fund; and Lansdowne UK, by far the biggest UK equity fund. While the average hedge fund was up about 8% to10%, all three of these were up by about 25% or more in 2007 as the year was drawing to a close.
It seems that, at a time when most of the big banks are writing off billions in credit-related losses, there has been a fundamental change in the markets – namely, a massive net transfer of wealth from the banks to the hedge funds. And many hedge fund managers I talk to remain excited about the opportunities – with volatile and dislocated markets continuing to offer a fertile environment.
Of course, volatility and dislocation create dangers as well as opportunities. So, looking ahead, there is at least one important caveat to bear in mind: many hedge fund strategies typically require some degree of leverage to work effectively. So most hedge fund managers – just like everybody else – will not want to see a prolonged crisis in the banking system. In the longer term, that would not be good for hedge funds either.