Why Nobody Makes Money Investing in Hedge Funds

Back in 2007, John Paulson guessed that declining house prices were likely to lead to a lot of defaults on subprime mortgages and placed a large bet on that proposition by buying credit default swaps. It worked out well, earned him $4 billion personally, and also garnered him a ton of media attention. And then:

After his success in 2007, the amount of money in his funds grew to more than $30 billion. Things went swimmingly until 2011 came along. His two largest funds, Paulson Advantage and Advantage Plus, lost 36 percent and 52 percent that year, and the red streak has continued into 2012, with Advantage and Advantage Plus down 6.3 percent and 9.3 percent as of the end of May.

The whole particular story of Paulson’s disastrous year is interesting, but the larger moral of the story is about why all these investment vehicles perform poorly on average. A fund manager is bound to get his maximum amount of investments after he makes a great call. After all, it’s the guys who make the great calls who you want to invest your money with. But at the same time, a lot of these great calls amount to luck. It’s true the very lucky guys who make the great calls seem super smart when you talk to them, but it turns out that the people whose bets go badly are also smart. The game is full of very smart people, none of whom change the fact that the future is unpredictable.