Wish we had thought of that...

Low-risk trades put all others in the shade

Within the hedge fund industry there are some trades that are destined to live on in legend: Jessie Livermore’s claimed $100m profit from shorting the 1929 crash, Paul Tudor Jones’ prediction of the 1987 crash, from which he doubled his money in a month, or the $1bn profit George Soros reputedly made when sterling was forced out of the exchange rate mechanism.

But the forecast last year by a select group of hedge funds of a crisis in subprime mortgages has put even the most spectacular trades in history in the shade.
EDITOR’S CHOICE
1000% hedge fund wins subprime bet - Nov-25
One hedge fund in 10 to go bust, says Man - Nov-20
View from the Top: Peter Clarke - Nov-20
Hedge funds on new ground - Nov-20
Jabre raising second hedge fund - Nov-05
Hedge funds home in on UK targets - Nov-05

Leading the pack of hedge funds which benefited from the subprime fallout is John Paulson’s New York-based Paulson & Co. Last year, it raised $2bn for two funds betting on falls in subprime mortgage-linked securities and they are now worth more than $8bn. By the end of October, the first of these funds was up 550.8 per cent, even after fees which included a quarter of profits.

His merger and event arbitrage funds – which would normally make bets on takeovers and other corporate deals – have also taken positions in subprime-linked securities.

Three of these funds more than doubled investors’ money with their short positions, and investors say that in total, Paulson funds have made more than $12bn from the subprime bet.

“There’s never been a trade of this size of profit ever in the history of financial markets,” says Arki Busson, chairman of EIM Group, which has $13bn invested in hedge funds.

As a result, Mr Paulson is likely to be the highest-paid hedge fund manager of all time when the performance fees crystallise, taking profits estimated by his own investors at between $2bn and $4bn. That would be enough to buy himself 18,000 Bentley Continentals, the hedge fund motor of choice.

“He’s really made a lot of money out of what has in essence been quite a conservative bet,” says one of Mr Paulson’s investors. “There’s no doubt it’s been one of the greatest trades of all time.”

When Mr Paulson was raising money for his new funds last summer, he claimed that “in his entire career he’s never seen such a big opportunity”, another investor says.

It is argued that Paulson has generated these enormous returns from taking relatively little risk.

Houston-based Centaurus Energy, for example, is reported to have made 317 per cent (before fees) last year by betting the opposite way on natural gas prices to that predicted by Amaranth, which collapsed after losing more than $6bn in a week. And Red Kite, the London hedge fund, made more than 250 per cent last year in its metals fund thanks to a successful highly-geared bet on copper prices.

Kyle Bass, who runs Hayman Capital, a Texas hedge fund, says the short credit trade is “by far the best risk/reward position I have ever seen”. A fund Hayman runs jointly with Corriente Advisors was up 526.5 per cent for the year to October, according to letters to investors.

All the short funds are likely to have made significant further gains this month as the credit squeeze caused subprime-linked bonds to lurch further down. An index which tracks these bonds, the ABX index of BBB credits issued in the first half of last year, has plummeted from above 40 to 25 this month, indicating big profits from those using derivatives to take short positions.

Andrew Lahde’s California-based Lahde Capital, for example, has gained about 40 per cent this month, to become the first of the group to pass 1,000 per cent return this year.

However, there may be little further money to make from the trade. Lahde has already begun to return cash to investors, while at the end of September Paulson told investors it saw only a further 30-40 per cent to make from shorting – and it made almost 22 per cent in October alone.

Paulson said then that it was still too early to start buying mortgage exposure, but that when the time came Paulson’s accumulated expertise in the 18,000 individual securities in the market should make it “uniquely positioned to benefit from future long opportunities”.

Some point out that there was widespread concern about subprime quality before the collapse, so the prediction of trouble was not difficult.

“In terms of monetising a trade it is potentially one of the successful trades of all time,” says Neil Meadows, head of fixed income and macro research at New Finance Capital, which has $5.5bn invested in hedge funds.

“But in terms of the intellectual capacity of it, I don’t think it was so hard – everyone knew it was coming. Perhaps not the scale of it or the timing, but they knew it was coming.”

Mr Busson, whose EIM group has money with Paulson, disagrees. He says the skill comes not only in predicting the crisis, but also in the execution of the trades. Mr Paulson – along with several other managers – constructed complex portfolios of the assets they believed would be worst-hit, rather than just shorting an index.

“[Mr Paulson] has always been a very professional hard-working research-oriented guy. With all these great trades, there’s no secret – you need to do an enormous amount of homework.”