August 29, 2011 8:34 pm
Not so happy returns
By Dan McCrum
Investments: Several of the industry’s most prominent names have had a disastrous year so far. Do they still have something to offer to retail investors and can they recover their losses?
It was the stuff of the American dream. “My father was a taxicab driver, and that made me a real happy kid because I knew I was going to do better than my father,” Bruce Berkowitz told a crowd of investors packed into a Columbia university auditorium in February.
His youthful confidence was well placed. Mr Berkowitz went on to become one of the most successful financiers of his generation – a fact acknowledged in 2010, when he was named domestic mutual fund manager of the decade by Morningstar, a research group.
Yet one piece of advice he handed down from the stage in New York proved wiser than the enthusiastic advocacy of financial stocks that it preceded. “The risks are the usual: what you don’t know; what you’re not thinking about; probably the biggest risk is what you are 100 per cent sure about,” he said.
Six months on, investors have begun to flee Bank of America, AIG, Citigroup and the other beaten down financial institutions that Mr Berkowitz had backed so confidently to recover. For Mr Berkowitz’s Fairholme fund, ranked last out of the 311 mutual funds in its category by Lipper, a research group, has lost 26 per cent of its value so far this year.
But he is not the only big-name investor to have combined overconfidence in the strength of US economic recovery with misplaced faith in the power of his own insight.
John Paulson, the hedge fund manager famous for making billions from bets that securities backed by subprime mortgages would prove worthless during the financial crisis, has also suffered as large bets on banks recovering have turned bad. Bill Gross, manager of the world’s largest bond fund for Pimco, has seen his widely followed call to avoid US government debt backfire.
“This is a natural phenomenon,” says Denis Bastin, a consultant to asset managers. “If you had a breed of super financial people who could always get it right whatever the market environment would be, well, all the wealth would be concentrated in very few hands and there wouldn’t be a market any more.”
But the fact that the “masters of the universe” have got it so wrong is a sign of how upside down the investing world is today. Everyone has struggled, with two-thirds of managers of stock funds failing to beat the S&P 500 index benchmark in the past three years, according to Standard & Poor’s.
On the eve of another September when banks are starting to eye each other nervously, as they did in the run-up to Lehman Brothers’ collapse in 2008, mere mortals face a rapidly shifting landscape. Ben Bernanke, US Federal Reserve chairman, only hinted at the possibility of further economic stimulus at last weekend’s annual gathering of central bankers in Jackson Hole, Wyoming. Christine Lagarde, head of the International Monetary Fund, warned that Europe’s banks needed more capital. With no sign of an end to today’s turbulence in sight, investors have a pressing question for the finance industry. Who on earth should they trust with their money?
It all seemed so different back in January. In his report to investors for 2010, Mr Paulson laid out arguments for a continuation of an economic recovery at that stage only five quarters old – a fraction of the six years of growth that followed the previous recession. The US government’s decision to extend tax cuts enacted under George W. Bush would give a two-year boost of $900bn to the economy, prompting several investment banks to update their economic forecasts, Mr Paulson told his investors.
“We have spent the last year and a half making restructuring investments in deeply distressed prices to maximise gains in an economic recovery,” he added. His conclusion, underlined for emphasis, was that “[we] do not want to be underinvested”.
Special attention was given to the position in Citigroup, a trade that had produced gains of more than $1bn in 2010 as shares in the bank rose 43 per cent. A modest note was made of the best long-term performance award from Absolute Return magazine made for Paulson & Co’s five-year record.
According to a person familiar with Mr Paulson’s thinking, he was also exceptionally keen on gold. When the Fed began to buy bonds in 2009 in an attempt to stimulate the economy, he was advised by Alan Greenspan, former Fed chairman, that this would ultimately lead to higher inflation as the economy recovered. So his $35bn hedge fund decided to allow its investors worried about inflation to transfer their holdings from US dollars into gold, using derivatives that track the price of the precious metal.
Inflation was also on the mind of Pimco’s Mr Gross, co-chief investment officer for Pimco and another recipient of a Morningstar award – fixed income manager of the decade – for his stewardship of the $244bn Total Return bond fund. He spent the first half of this year warning investors that holders of US Treasuries were not compensated for the risk of higher inflation by the low interest rates on offer. “Bond holders are being duped into thinking that inflation will renormalise to justify existing yields,” he said when 10-year Treasury yields stood at 3.5 per cent.
The value of a Treasury’s fixed interest payments is eroded by inflation. Mr Gross expected interest rates to rise when the Fed stopped buying bonds as part of its quantitative easing stimulus programme at the end of June, which would cause their price to fall. So he emptied the Total Return fund of securities related to the US government and waited for rates to rise.
Treasury investors, he said in June, were like frogs unaware that they sat in slowly boiling water. Events, however, intervened and the water was not bubbling. Slowly but surely, it was starting to cool.
The exact moment when markets began to notice the change is not clear. Investors were distracted by the debate over the debt ceiling in Washington and then jolted by the downgrade to the US sovereign credit rating by S&P at the start of August.
But both followed a steady trickle of news that showed house prices were not rising, consumers were not spending and the unemployed were still not finding jobs. When the downgrade arrived, investors were already starting to feel very uncertain about the future.
Stock markets fell, financial stocks fell further and the US 10-year bond yield dropped below 2 per cent, a 61-year low. It took a surprise $5bn investment by legendary investor Warren Buffett last week just to halt the slide in BoA's share price.
Mr Paulson’s flagship Advantage Plus fund was down 39 per cent for the year by mid-August, according to investors. Mr Gross, trailing his benchmark, slipped to 501st among his 584 bond manager peers, his status as a bond guru under threat.
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All three could still make their way back. Mr Berkowitz and Mr Paulson – who both declined to comment for this article – base their faith in financial stocks on a recovery that has been postponed, not cancelled.
“One day our banks will be considered the safest investment in the stock market. They are the financial system of the US,” Mr Berkowitz told the Financial Times in July.
A value investor who seeks out cheap, unpopular assets, he compared his position in financial stocks with his faith in US insurance companies when investors feared the sector would be crippled by reforms to the healthcare system. In the event, the reforms did not go as far as the industry feared and share prices recovered.
For Mr Paulson, the mitigation of his bet on gold, where the price is up 8 per cent since the start of August, may persuade investors to stick by him and hope for a recovery.
For Mr Gross, meanwhile, who has started to buy Treasuries again, deep and liquid bond markets have allowed him to change his mind, and his positioning, without markets moving far against him.
“Do I wish I had more Treasuries? Yeah, that’s pretty obvious,” he told the FT in an interview last week, adding: “I get that it was my/our mistake in thinking that the US economy can chug along at 2 per cent real growth rates. It doesn’t look like it can.”
However, the question of whether big name fund managers can bounce back points to a paradox at the heart of investing: patches of dire performance can be a feature of smart investors. “The best managers have clear and consistent investment philosophies to which they adhere fairly strictly, even when this philosophy leads them to investments that are out of favour in the market,” says David Shukis of Cambridge Associates, a US investment consultancy.
Cambridge calculates that, of the investors it tracks who feature in the top quarter by performance over the past decade, about half have spent at least three years in the fourth quartile.
“Value investors are not known for buying things at the absolute bottom, but buying things on the way down,” says Michael van Biema, founder of a New York-based fund of hedge funds.
But the industry also has plenty of examples of successful investors and funds that lost what made them tick when the market environment changes.
Bill Miller, a previous Morningstar manager of the decade, who could do no wrong through the 1990s, has struggled with poor performance since 2005. Now his Legg Mason Capital Management Value Trust is ranked last of the 840 funds in its category over the past five years by Lipper, losing 9 per cent annually.
Fidelity’s Magellan fund, which invests in fast-growing companies, boasted $106bn of assets at the turn of the millennium. In the three years that followed, it lost money and has since dwindled to less than a fifth of its former size.
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I’ve always felt that one of the biggest mistakes that investors make is they hire ‘concentrated managers’ [who take big positions in a small number of] equities after they’ve gone from $1bn in management to $20bn or $40bn or more,” says Jeffrey Gundlach of Los Angeles-based Doubleline Investments.
Essentially, he argues, as managers perform well, they attract more money from investors, that is then added to their existing holdings, boosting their value further. But when something happens to alter the trend – a profit warning, say, or a broad shift in market sentiment – that virtuous circle can turn vicious as investors take their money back, forcing the manager to sell.
Mr Berkowitz’s Fairholme fund, for example, went from assets of less than $50m at the end of 2002 to almost $20bn in February this year, before dipping back to $13bn after this month’s rout.
But such insights offer little comfort to investors contemplating another year of poor returns. The problem for the industry is that it needs investors to believe in the power of its superstars rather than focusing on the failure of managers, in aggregate, to perform.
Billions of dollars in fees rest on investors continuing to search, and pay, for top managers. High-profile failures only reinforce the unwelcome evidence that good performance is almost impossible to predict.
“This is a fact of life,” says Mr Bastin, adding: “You cannot seek out short-term performance and expect good long-term returns.”
MACRO FUNDS: For the contrarian, size and regulation boost returns
In the August market turbulence that caught many investors unprepared, one group has stood firm: the so-called global macro funds that aim to profit from shifts in the world economy by trading in bonds, currencies, rates and equities, write Dan McCrum and Sam Jones.Returns for the average global macro hedge fund are down 0.2 per cent so far this year, according to Hedge Fund Research.
And until recently, returns for the year have been largely flat for Brevan Howard, one of the largest funds. But the $32bn London-based fund has added $1.5bn since the start of this month, leaving it up more than 11 per cent for the year, say investors.
New York-based Paul Tudor Jones’s flagship $7bn Tudor BVI Global fund gained 3 per cent this month, clawing back earlier losses to put the vehicle in positive territory.
Bigger funds have done better than their rivals, in part thanks to investor confidence in their ability to weather choppy market conditions. Smaller funds are often forced by their brokers to exit lossmaking positions before they recover.
At the same time, structural changes to the market arising from US financial reforms have made it hard for them to get out of positions quickly. The Dodd-Frank act has forced banks to restrict speculative trading, which increasingly leaves bigger funds as the only major operators – and with fewer counterparties with which to trade.
As a result, says New York-based Arvin Soh of GAM Trading: “The large funds can still put the trades on but they can’t get out in a hurry so they’ve been forced to think of ways to construct trades that allow them to hold on.” They have had no choice but to ride out the turmoil – at times to their benefit, he argues.
For the remainder of the year, funds will have to navigate an unusual level of political risk, as traders grapple with Europe’s sovereign debt crisis and central bank measures to forestall recession.
Contrarian funds may also find the next few months frustrating, says one veteran trader: “The problem for macro guys is that they are by and large pessimists.” But after the summer convulsions, he adds, there is less optimism to bet against.
Copyright The Financial Times Limited 2011.
