Putting a Price on Tim Cook's Value as Apple CEO

The case of Apple shows it is very hard to judge whether a corporate CEO is worth a lot of money or not.

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Takeaways From 'The Greatest Trade Ever'

By Eric Jackson
RealMoney Contributor
12/2/2010 12:00 PM EST
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It was an interesting exercise to reflect on what book has had the biggest impact on me as a trader or investor. I'm picking a recent book that recounts the history of John Paulson's bet on a collapse of subprime housing in 2006-2008: Greg Zuckerman's The Greatest Trade Ever.

Most people I talk to about the book have been drawn to it because of the money Paulson made -- several billions personally -- and they are amazed that he was able to see in advance what everyone now sees as obvious after the fact: Housing's explosive growth was illusory, built on a sand foundation of easy credit.

As an investor, you can't help but be impressed by the returns that Paulson scored. However, the pearls of the book are the little things you notice about his process of approaching and then executing the trade. These actions are replicable, even though the trade itself is not.

Here are my key takeaways from the book:

1. Don't let others label you, and more importantly, don't label yourself.

John Paulson had been a moderately successful merger arbitrage guy. He raised money from investors with that as his mandate. People expected him to keep using that strategy. Most hedge-fund managers at that stage of their careers would be on auto-pilot. After all, he could have kept making good money doing just that. Even though he had no housing experience, he wasn't afraid to jump in when he saw the opportunity. Many of his longtime investors weren't happy. This wasn't what they signed up for when they gave him their money. Paulson didn't care. He saw the opportunity and didn't let others, or his own reservations, get in the way.

2. The biggest trades require planning and a refutation of conventional wisdom.

I have never been drawn to momentum trading or studying charts. I know lots of people who do it and are fantastically successful.

...

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Soros' Opinions Given Too Much Weight

By Eric Jackson, Senior Contributor11/17/10 - 06:00 AM EST

George Soros is arguably the most famous first generation hedge fund manager in the world.

A quick search of the 80-year-old's name yields 2.5 million hits on Google. Julian Robertson, 78, yields 740,000 hits. Carl Icahn, 74, generates 400,000 hits. (If you want to characterize Warren Buffett as also a first- generation hedge fund manager, the 80-year-old wins the popularity contest with 3.6 million Google hits.)

Of the current set of modern hedge fund managers, only John Paulson yields more Google hits than Soros, with 2.6 million hits. Soros has about 10 times the number of hits as the man David Rosenberg calls the best money manager in the world: Paul Tudor Jones. David Einhorn has only 225,000 hits and Bill Ackman generates only 84,000 hits. Eddie Lampert, who was once declared the next Warren Buffett, has only 32,000 hits.

Of course, past performance -- and hits on Google -- by no means indicate future performance. Yet, these hits indicate how often the broader media pay attention to the views of these managers as a part of the public discourse on our financial markets.

Popularity of these managers is why CNBC and other media outlets pay so much attention to their 13-F filings, which disclose how their portfolios change each quarter. For example, earlier this week, we found out that John Paulson trimmed his Bank of America(BAC_) stake last quarter and sold his entireGoldman Sachs(GS_) stake. David Einhorn bought more Apple(AAPL_).

In a Wall Street Journal story yesterday, we also learned that Soros "reduced his direct ownership stake in the SPDR Gold Trust(GLD_)" and he "reported no stake in Best Buy(BBY_)."

To the Journal's credit, it also referenced that it was Soros' hedge fund -- Soros Fund Management -- which made other moves. In one paragraph, the Journal uses Soros and his fund interchangeably: "The value of Mr. Soros's stockholdings was $6.7 billion at the end of the third quarter. The fund reported stockholdings worth $5.1 billion at the end of the second quarter."

However, in an hour long discussion with Reuters' Chrystia Freeland in September, where he discussed his macro views on gold, the U.S. deficit, and Europe's debt problems, Soros admitted during a Q&A session afterwards when asked about one of his fund's stock positions that he wasn't involved in the day-to-day decisions of the fund. Therefore, he couldn't discuss a specific stock.

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Digging for Gold Among the Miners

By Eric Jackson
RealMoney Contributor
9/7/2010 11:30 AM EDT
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There's been a lot of excitement about the mergers-and-acquisitions action in the tech sector lately. That has naturally spurred a great deal of speculation as to what other companies might be taken out next -- and, currently, those same dynamics are also present in the gold sector.

Last week, Goldcorp (GG - commentary - Trade Now) announced it had agreed to buy Andean Resources for roughly $3.46 billion, topping another bid from Eldorado (EGO - commentary -Trade Now). Australia-based Newcrest Miningrecently completed its purchase of Lihir Gold, a deal that was worth some A$9.5 billion as of early May. Additionally, Kinross Gold (KGC -commentary - Trade Now) agreed to buy Red Back at the start of August.

We're likely to see a number of similar deals to come, wherein the big gold players -- names such asBarrick Gold (ABX - commentary - Trade Now), Goldcorp, and Newmont Mining (NEM - commentary -Trade Now) -- look to buy assets of some of the junior gold miners.

Why will these gold majors buy now? There are several reasons:

• They have the cash and currency to do so. Just as in the word of large-cap tech, these large majors weren't doing deals two years ago when the walls were closing in on the global economy. The market hasn't returned to the 2006 buyout binge days, but the stock market has at least recovered enough to make the head honchos sufficiently confident to green-light deals.
• The price of gold is near $1,300 an ounce. If you were a CEO of one of these large majors, you'd think twice before going to your board to buy an attractive junior at a time when the price per ounce of gold had collapsed (as had been the case in early 2009). You'd know that would be a tough sell, and that a few directors would be likely to ask, "What's the rush?" The higher price at this point means these boards will likely feel more confident in the economics of buying these assets.
• A physical scarcity of gold has made these juniors even more attractive. There are 162,000 tons of gold in the world. That's it. Printing presses can't print more gold. Therefore, given that gold prices are hovering near all-time highs and that some are predicting event stronger upward moves, it makes sense for these large majors to act now and get a piece of the action.
• These large majors need to add reserves each year. Barrick, in 2009 alone, produced 231 tons (or 7.4 million ounces) of gold -- which means it reduced its reserves by that amount. These large players need to keep filling the top of their reserves funnel in order to show their investors that they are keeping their reserves high. They can't do that through new finds by themselves. They need M&A.

So, as to the virtually certain coming tide of consolidation in the gold space, I like these juniors:

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Gold Running in Short Supply: An Interview with Eric Sprott

By Eric Jackson, Senior Contributor06/09/10 - 06:30 AM EDT

Stock quotes in this article: PHYS , GLD

Eric Sprott founded Sprott Asset Management in 2001 and has over $5 billion in assets under management. He has been an outspoken gold bull since 2000 and warned that the bursting of the Nasdaq bubble was the start of a long-term deflationary trend that is playing out. I met him last week in Toronto.

First of two parts

EJ: You've been one of the biggest gold proponents. Where's the price per ounce of gold going?

ES: I don't have a good price target. We get involved in themes that play out for a long time. Interest ratesand reported inflation started going down in the 1980s. No one dreamed of buying gold in 2000. You were an idiot talking about it. I was initially attracted to it because I thought there was a physical shortage then. There still is.

Central governments were selling gold 10 years ago. This put a burden on a very small market. Today, central governments are buying, the miners are unhedged, you have big gold ETFs, you have coin sales going crazy. Some central banks are even telling their people to buy gold.

I've got to believe that a physical shortage will manifest itself somewhere soon. There's only 162,000 tons of it out there -- and I don't know anyone selling it. Someone's going to try to buy a bar of gold sometime and it won't be there.

My partner, John Embry, went into gold many years ago because he thought it would become a substitute for fiat currencies. Governments are printing money and, sooner or later, people will realize that it's better to own gold than any bank deposits. This theme is obviously massively playing out as we speak. You look at the quantitative easing (QE) programs, budget deficits. The global fiscal irresponsibility plays into the hands of the gold owner. More people will figure it out and they'll go there.

We now have large investors -- John Paulson, to name one -- putting their money into gold. If everyone started putting 5% of their portfolios in gold, there wouldn't be enough. I'm convinced the upside for gold is still quite positive. When I see some projections for $2,000, $3,000, or $5,000 per ounce, none of them bothers me. We don't know where the price will go but it will be the inverse of QE. The more they print, the more it will go up.

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Reasons to Like Citigroup Again $C

By Eric Jackson

RealMoney Contributor

3/11/2010 8:00 AM EST

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Over the past year, I've been very critical of Citigroup (C - commentary - Trade Now) CEO Vikram Pandit and of the company's improved but still-deficient board of directors. Perhaps there's no greater example of a once-great company laid low by the financial tsunami of 2008 than Citi.

Yet, the company, which has been plagued by persistent bad press for the better part of two years now, seems to have turned the corner, with investors taking particular notice in the last week. Yesterday, the stock touched $4 for the first time in three months.

It's time to give Citi its due, and it's time to get long the stock. Here's why.

Vikram Pandit has been abysmal CEO, but he is actually learning from the massive criticism he's received. Pandit has done himself no favors since taking the top spot from Chuck Prince. He told a reporter after his ascension that he called his father in India to tell him of the good news by saying, "The Prince has gone and the King has come." Last week's performance of Pandit in front of the TARP oversight committee and with media afterwards was beyond reproach. He struck just the right tone of modesty and wanting to do what's right for Citi shareholders and the country. If he can be coached here by his PR team, it gives me hope that he can also be coached in improving some of the other parts of Citi that need work.

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Paulson is About Performance

By Eric Jackson, Senior Contributor

11/25/09 - 06:02 AM EST

Stock quotes in this article: BAC , C , SHLD

There were two reactions I got to my column last week on Greg Zuckerman's new book The Greatest Trade Ever about John Paulson's $20 billion bearish housing trade in 2007: "He was lucky" and "He won't do it again."

Even though these comments are mostly sour grapes, here's the problem with overanalyzing winners -- for the financial media, potential investors and even money managers, like Paulson himself.

Our society celebrates winners (athletes, politicians and investment managers like John Paulson) and ignores losers. From 1994-2007, in the eyes of many, Paulson was a loser. His hedge fund, Paulson & Co., had mediocre returns during this period. He was defined as a merger arbitrage guy. Because of this categorization, some investors were alarmed by his ideas about betting against the housing market using credit default swaps. Yet, he did -- and we know the results.

John Paulson, hedge fund manager

Although his pre-2007 performance didn't stand out, people who knew Paulson thought highly of him, according to Zuckerman. Investors were often impressed with his understated but effective way of clearly articulating his investment theses.

Post-2007, the perception of Paulson went from career underachiever to seer. He is now celebrated, and his recent stakes in Citigroup(C Quote), Bank of America (BAC Quote) and gold are seen as green lights to other investors to buy.

If Paulson told us tomorrow that Martians were going to invade us next month, there would be a run on Martian army gear.

Yet, this reaction is equally superficial in the opposite direction. We don't care why he thinks gold is a buy or why Bank of America will double in two years. This isn't Paulson's fault. He can't help it. It is the reality that's developed around him while he's gone about his business trying to make money for his investors. It's exactly the same as the heavy attention paid to Warren Buffett's moves.

This is classic "survivorship bias." There were 20,000 hedge funds in the halcyon days of 2007. No matter what the markets did over the next 18 months, five to 10 funds would have had scored 100%-plus returns and been celebrated. If Bernanke had cut interest rates drastically in 2006, maybe New Century would have continued to be a huge moneymaker by issuing subprime mortgages.

David Einhorn would be known today as having the canny intuition to get long that stock (and join its board) in 2006, instead of for calling Lehman's implosion in early 2008. Had the housing boom continued, perhaps Greg Zuckerman's book would be about former Bear Stearns hedge fund manager, Ralph Cioffi. Of course, this didn't happen and, instead, Cioffi is fighting civil charges by the SEC, and John Paulson is the hero.

Survivorship bias leads to celebrating the winners and -- usually -- overinterpreting their moves leading up to their success and trying to apply these actions to future situations. At least no one in the mainstream media has yet called John Paulson "the next Warren Buffett."

Remember Eddie Lampert? That's what Business Week and countless other magazines called him back in 2004. Although many still defend Lampert as smart, his past five years of performance have been very disappointing, and his Sears Holdings(SHLD Quote) investment specifically has been ... early.

Although it's easy to pick on the financial media for these flubs in hindsight, they are merely reflecting our own deep-seated human desires for making sense of a seemingly senseless market. They wouldn't tell us who'll be the next Warren Buffett, unless we wanted to buy their magazine (or click on their links) to find out. We gravitate to "winners" for pearls of wisdom to help us be more winnerlike.

This is why investors "performance chase." The best performing hedge funds (and mutual funds) will always attract the most capital. After all, performance is what it's all about. Most investors will overlook lots of quirks, ethical lapses and hard-to-follow musings about the state of the markets in investor letters, if the money manager performs.

The longer and better he or she performs, the more leash we give him or her (like Madoff) or the more we celebrate him (like Peter Lynch, Lampert and now Paulson). But past performance (and a fund's ability to raise capital) is no guarantee of future success.

Investors should judge money managers on their current ideas. If you'd done so when John Paulson made his argument for why to bet against housing in 2006 and 2007 -- despite the fact that he wasn't a "housing guy" -- you made a lot of money. His pro-gold and pro-financials views now should be also judged on their merits, not because "John Paulson thinks so." Of course, you and I will probably never have the chance to place money with Paulson. So this lesson becomes even more important. How are you going to know the next John Paulson when you bump into him or her?

Finally, let's turn to the critique of "Paulson will never do it again." Most people assume that smart people will, over time, outperform their peers. This is true. Yet, we also know smart people drove Enron, WorldCom and Lehman Brothers off cliffs -- all companies that, before their collapses, had been celebrated in the financial media with books written about them "getting it" while their competitors didn't. How can this happen and how can Paulson avoid this fate?

Michael Burry, a doctor-turned-hedge fund manager also profiled in Zuckerman's book, who also profited from betting against housing despite great protestations from his investors, had a memorable line: "A money manager does not go from being a near nobody to being nearly universally applauded to being nearly universally vilified without some effect."

Paulson's gone from obscurity to being perceived by many as the top hedge fund manager in the world. With that change, Paulson has received enormous wealth, but at a cost. His every trade gets discussed and debated in the media. He's likely become more isolated for security reasons, making it harder to relate to the "real world" in which his investments operate. And he likely has more "yes men" around him than ever before.

If you're on Paulson's team, you've made huge money recently. Unwittingly, you'll start agreeing with him more on his new investment ideas. Anyone who doesn't agree will probably leave on his own accord or be asked to leave. Those remaining on the team are the most loyal and the least likely to disagree with the boss' views. Active debate helps form great investment ideas. But, as money managers get more successful, they face less and less debate.

I disagree that John Paulson was lucky in betting against housing. From Zuckerman's account, Paulson did his homework, while everyone else stayed too long at the party. I also think that he can still conceive of and execute great trades. But there's no question that it will be more difficult now than before . Ask Lampert. Paulson's continued success is not his birthright.

Any investor choosing a money manager needs to remember the story of the emperor's new clothes. Managers like to dazzle investors with technical terms and fancy charts. However, they should be able to clearly and articulately explain their basic strategy. No amount of buzz or press clippings is an adequate substitute for clear-headedness. (In fact, if they seem overly concerned with their media appearances, this signals they care more about their image than managing your money.) You shouldn't worry about asking a stupid question. If they show a whiff of arrogance in responding to your questions, run away as fast as you can.

Answering these questions will help you skate to where the puck's going, not where it's been. It will also help you ensure differentiating between "flash in the pan" money managers from those with staying power. And, just maybe, you'll find the next John Paulson.

At the time of publication, Jackson fund held no positions in the stocks mentioned.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

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The Lessons of John Paulson & The Greatest Trade Ever

By Eric Jackson, Senior Contributor 11/18/09 - 06:00 AM EST

Stock quotes in this article: C , GS

If it wasn't clear already that John Paulson had reached the zenith of his hedge fund profession, one only had to watch how fervently the media and blogosphere digested the news of Paulson & Co.'s quarterly holdings which was released last Friday.

Market commentators immediately pounced on how the one-time housing bear had loaded up on 300 million shares in Citigroup(C Quote) during the quarter, while dumping his entire holdings in Goldman Sachs(GS Quote).

Similar 13-F holdings of other hedge fund managers like David Einhorn and George Soros filed with the Securities and Exchange Commission in recent days have been summarily ignored compared to the reaction to Paulson's. (Citi shares jumped 3.2% the day after Paulson's announcement, far outpacing the S&P and Financial index that day.)

As far as hedge fund managers go today, John Paulson is the man. Ken Griffin, Stevie Cohen, and Eddie Lampert and others are afterthoughts.

In Gregory Zuckerman's new book, The Greatest Trade Ever, the Wall Street Journal reporter chronicles how Paulson mounted his ascent from nobody to this industry's seer of the moment.

Seven years ago, Paulson was relatively unknown. He was a merger-arbitrage guy running $300 million dollars. The former Baker Scholar from Harvard Business School couldn't help but feel that - in his mid-40s - he had under-achieved his career potential.

A key analyst alongside Paulson was Paolo Pellegrini. A failed Lazard banker with two divorces and zero net worth at the time he joined Paulson, Pellegrini had to make this last career chance work.

He lived in a one bedroom apartment up in Westchester and would arrive at work at 6:30 am in order to get the cheapest parking lot rate nearby. No one seemed to like him at first. He was a bit of a hot-head and talked too much. Yet, eventually he helped identify the housing bubble that Paulson would turn into a $16 billion winning trade for his firm and $4 billion for Paulson.

Beyond the interesting outsider-type characters working at Paulson, Zuckerman's book offers many lessons for small and large investors. One is the risk, but potential reward, that comes from breaking away from the herd mentality that surrounds Wall Street.

Nobody on Wall Street gave these guys a chance, when they started betting against housing. In fact, Paulson was routinely laughed at. Because the banking infrastructure was making so much money off of housing in 2004 - 2006, there was no reason for so many people to imagine it would end.

Even among hedge funds -- who are paid handsomely to anticipate and invest in where the puck is going, not where it's been -- precious few made this bearish trade. At the time, wise managers saw only the obstacles to the trade working out (like the federal government bailing out sub-prime borrowers and "containing" the problem from other parts of housing) and they clung to a misplaced blind trust in "their models" which showed housing couldn't decrease in value.

Even after he makes the bet, Zuckerman points out how there are so many times that people tell Paulson to take the bet off or cash in his profits too early. His own investors complained. Complaints also came from brokers from Bear Stearns and others who helped sell him the credit default swaps on the toxic tranches of mortgage bonds, as well as the most troubled sub-prime lenders and banks holding the troubled securities.

Even his own staff complained that he wasn't taking money off the table. They told him to sell when he was down in his trade and they told him to sell when he was up on the trade after New Century reported its first blown quarter in early 2007. Through it all, Paulson stuck to his guns because he foresaw even bigger profits ahead - and he was proved right.

As a fund manager, I often ponder the challenge of balancing between (1) trusting yourself and your investment thesis completely even when no one else does and (2) being aware enough to know when you're being too stubborn and "not seeing the facts" or when the trade is going against you.

In Paulson's case, every new bit of data which came to light and possibly contradicted his investment thesis was always scrutinized by him and his team to see if they had "missed something." He always stuck with the trade because he felt confident in the depth of research they had invested in understanding the problem/investment opportunity.

For Paulson, it all boiled down to one chart which Pellegrini produced showing the inflation-adjusted growth in housing prices over time divided by wage growth. The data clearly showed a rapid explosion upward away from the general trend starting in 2000. He assumed this trend would not continue indefinitely and revert (even overshoot). He was right.

The Greatest Trade Ever isn't just about John Paulson. It describes some smaller players who also bet against housing. Their stories are also very interesting and some of the characters are really colorful and interesting. Some run into the problem of not having enough capital to implement the trade to the degree they want to. Some wait too long.

One investor, Michael Burry, got his break as a fund manager when well-known value investor Joel Greenblatt made a big investment in him. Later, after taking a big bet against housing early on, Burry faced Greenblatt's wrath. In no uncertain terms, Greenblatt told him to get out of the trade. Burry didn't but not without taking a huge mental and physical toll on himself. Put yourself in Burry's shoes. What must it have felt like to tell your maker to take a hike?

There are several lessons in The Greatest Trade Ever for investors: believe in yourself (assuming you've done your homework), be skeptical of others' free opinions and assumptions, persist, and take the long view and don't take profits too early.

Every investor involved in this bearish housing trade early on referred to it as their potential "Soros trade" - referring to the famous 1992 bet against the British pound which netted Soros' fund $1 billion.

Paulson used this line himself, but he also remembered another Soros comment that stuck in his mind as he executed his trade. When you see the perfect trade set-up in front of you, Soros advised to "go for the jugular." Paulson did and it paid off big-time. Some of us will never see a trade like that for the rest of our lives. When opportunity knocks, you have to answer.

At the time of publication, Jackson's Fund had no holdings in any of the equities mentioned.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

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Hedge Funds: The Road Back

From TheStreet.com

By Eric Jackson

03/06/09 - 11:05 AM EST

Last November, fund-of-hedge-funds manager Sandra Manzke of Maxam Capital Management sent out a Jerry Maguire-esque letter to her investors in which she stated that she was "appalled and disgusted" by the behavior of hedge fund managers today.

They no longer acted with investors' interests in mind, she said, as they did 25 years ago when she founded Tremont Capital. Managers today followed questionable practices like "gating, side pocketing, suspension of redemptions ... attempting to get their money out ahead of investors, [and] eliminate[ing] high water marks".

At first, Manzke was portrayed as a whistle-blower trying to get the rest of her greedy industry in line. Then, Bernie Madoff happened. In the fallout, it came to light that both Tremont and Maxam were heavy Madoff investors. Earlier this month, both firms separately announced they would have to shut down as a result of Madoff-related losses. Ironically, the firms (like many Madoff investors) did little to no meaningful due diligence and were content to play middlemen for a performing product and collect their fees. The would-be reformer should have started her efforts in her own backyard.

Hedge funds are much maligned in the press and by politicians these days. They do have some failings which need correcting, which I plainly see as a hedge fund manager myself. However, the industry will continue to attract talent, innovative strategy, and capital as a result in the coming years. Here are some of the problems with hedge funds but reasons why the industry is still an attractive place for your money.

Gating While Charging Fees is Unacceptable

A number of funds -- large and small, including ones with formerly sterling reputations such as Citadel, Farallon, and DE Shaw -- have exercised their rights to enforce a gate in the last few months, reducing how quickly investors can redeem out of the fund. The intent of a gate is to prevent a panicked run on the fund, requiring forced selling, which can be very difficult for funds holding illiquid assets, and which further lowers the value of the remaining investors' assets in the fund.

John Paulson, whose fund was up 38% in 2008, has criticized fellow managers for invoking gates, and Leon Cooperman, who runs Omega Advisers, told The New York Times "you'd have to lower me into the ground before I'd put up a gate."

In my view, erecting gates is not ideal but defensible for a manager, since the possibility is fully disclosed to investors up front. However, it's deplorable that so many hedge fund managers have recently put up gates and then continued to charge fees after doing so. That certainly hasn't engendered goodwill with investors.

Among the funds still charging full or partial management and performance fees after erecting a gate, according to several industry participants I've spoken with: Citadel, Cerberus, and Highbridge Capital Management. One fellow manager expressed deep frustration at this practice of charging fees post-gate: "It's almost criminal. It gives all of us in the industry a bad name." Some funds are doing the right thing: Farallon is not charging fees to its investors kept in by their decision to use a gate last fall.

And, of course, just as no one is paying attention to the consumers who never got themselves into a loan they couldn't afford, let's not forget the many funds that had down years in 2008 and yet imposed no gates. They've given up fees on capital that left but could have been forced to stay. Some of the funds taking the high road are Atticus, Clarium, Harbinger, Maverick, and Tremblant. These funds faced the same "unprecedented" or "Perfect Storm" market conditions and yet were still able to maintain adequate liquidity and confidence in the marks on their positions in order to pay out requested capital to their investors. These funds are taking the long-view on this issue and will benefit in future fund-raising when this current down cycle turns.

Pay for Performance Works

Hedge fund critics are quick to jump on the issue of manager compensation. Critics say hedge fund managers should always make money, no matter the market or the strategy being followed. But not every hedge fund manager is following an absolute return strategy. One of the great things about hedge funds is that there is such a diverse choice of strategies and exposure levels.

Sadly, some hedge fund managers don't help themselves in the court of public opinion -- call it John Thain-itis. Most profiles of hedge fund managers include references to private jets, homes in the Hamptons, and flashy lifestyles. Discussions about managers giving to the Robin Hood Foundation are less common. A fund-of-hedge-fund manager recently told The Wall Street Journal: "I was definitely overpaid in the good times and now I'm definitely being underpaid in the bad times."

Those comments don't put anyone in the industry in a good light (especially that manager) but, at the end of the day, these comments or whether some manager buys a flashy car, has no predictive value on whether a hedge fund is a good investment. The truth is that hedge fund managers basically will only survive as a firm if they perform. If not, they'll be out of business (as many will in the next six months) and going into a different industry.

Most investors I know don't mind paying fees, as long as they get acceptable performance. When they don't, they redeem -- as they are in spades at the moment in the industry.

Don't Tinker With High-Water Marks

Hedge funds typically have high-water marks, which require managers to make their investors whole before resuming paying themselves performance fees. These high-water marks are going to cast a large shadow in the industry for the next few years. Ken Griffin of Citadel, which dropped 55% in 2008, said recently that he and others at his shop would only be working for "psychic income" for the next few years, as they crawl out of their negative performance hole.

Some critics have said that high-water marks are not the panacea they seem. If you have a down year, these critics say, you can just shut down your fund to avoid the pain of making back past losses and open another shop up across the street. Although this can and does happen, it's equally common for hedge funds to honor their high water marks instead of taking the "easy" way out and shutting down, eliminating the high water mark, and re-opening later.

There are examples of shirking performance responsibility in smaller hedge funds. In early 2008, before the real stock market pain hit, Dan Zwirn was forced to shut his hedge fund DB Zwirn & Co. when it came to light that he had improperly paid for a jet with investors' money (amongst other back-office issues). His performance had been steady and successful prior to those revelations. Zwirn claimed the improprieties were the fault of poor back-office oversight by his CFO and wasn't linked at all to the strategy he had overseen successfully.

Because his strategy involved stakes in many illiquid assets, it will take time to fully wind down DB Zwirn. However, only a few months after the decision to shut down, rumors began to circulate that Zwirn would be launching ZLC Global -- a new fund following exactly the same strategy as DB Zwirn & Co. Many DB Zwirn & Co. investors were going to be investing in ZLC Global, according to reports. It is puzzling that some investors can be so forgiving, but this behavior is isolated and does not undermine the value investors' gain from high water marks.

Some hedge fund managers have tried to bend the rules in their favor to collect more in fees. For example, Steve Mandel of Lone Pine Capital abides by a high-water mark but can get some portion of a performance fee the next year, if he surpasses a hurdle. In other words, you don't always have to live off psychic income if you had a bad previous year.

Another bad practice that should be changed is when hedge funds insist on long lock-up periods -- say three years -- during which they still pay themselves management and performance fees annually. They don't typically claw-back their year one performance fees if they have a major performance drop in year three.

Investors will rightly have less tolerance for these "innovations" going forward. If managers screw up, they need to pay the consequences. It's that Darwinism which makes the industry strong and should give no investor qualms about having to pay performance -- or more correctly stated, revenue-sharing -- fees.

Conclusion

The hedge fund industry will work out its excesses carried over from the last five years and become a stronger collective of funds and fund managers. Most of the lemmings will leave, until the industry once again begins to experience excessive growth. Oversight must and will improve. Lessons should be learned. But in one, five, and 10 years from now -- no matter the macro environment -- investors will still flock to hedge funds because it attracts the best managers with the most creative strategies.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

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The Good, Bad, and Ugly in Hedge Funds: A Manager's View

From BusinessWeek

By Eric Jackson

March 5, 2009, 12:01AM EST

BusinessWeek reader and hedge fund manager Eric Jackson considers the pros and cons of his industry

Not too long ago, practically every newly minted MBA wanted to be a hedge fund manager, and investors—including many conservative pension funds and endowments—rushed at the chance to place assets in hedge funds. Yet hedge fund managers were blamed for both artificially inflating the price of oil last summer and, when prices dropped, for contributing to the looming recession.

The mainstream press has now taken to derisively calling them "former masters of the universe," while noting that compensation is still "obscene." As quickly as assets came in during the up market, they have gone out in a declining market. In the last quarter of 2008, $152 billion in hedge fund assets were redeemed, even ones with positive returns in 2008.

As a hedge fund manager, I'm neither an apologist nor a cheerleader for my industry. Like any business, the hedge fund world has good and bad practices and managers. All managers need to accept accountability for the trying times we are living through. But it's fanciful to suggest hedge funds are about to disappear. Quite the opposite: The industry will be thriving even five years from now because it will continue to attract the best managers and the most sophisticated investors seeking alpha through innovative strategies. Here are some of the good and bad practices in the industry today:

Barbarians at the Gates

Hedge funds have long had "gates" as options available to the fund and/or manager included in their subscription documents. All investors reviewed these prior to making an investment. You haven't heard much about them because hedge funds haven't gone through a sustained down period the way we have in the past six months. As a result, a number of funds have exercised their rights to enforce a gate, reducing how quickly investors can redeem out of the fund. The intent of a gate is to prevent a panicked run on the fund, requiring forced selling, which can be very difficult for funds holding illiquid assets, and which further lowers the value of the remaining investors' assets in the fund.

Gates are a perfectly legitimate operating mechanism and will continue to be part of hedge fund investing. Moreover, as so many funds have decided to use them in the past four months, it is unlikely any one fund will be unfairly penalized by investors when they raise new funds down the road. The managers who will be penalized for putting up a gate are the ones who continue to charge fees after doing so. That's their right under their agreements, but it certainly doesn't engender goodwill, and investors tend to have elephant-like memories.

Overpaid and Underperforming?

Critics have attacked the standard hedge fund compensation model of 2% annual management fee and 20%-of-profits performance fee in light of the industry's poor 2008 performance (-19.2% for the average fund, according to Hennessee Group). Yes, many hedge fund managers made bad calls in 2008, but one-third of hedge funds made money in a year when the Standard & Poor's 500-stock index was down 40%. Only 1 in 1,700 mutual funds made money in the same period, meaning you were 50 times more likely to make money in a hedge fund compared to a mutual fund last year. What is that worth in fees?

Sadly, some hedge fund managers don't help themselves in the court of public opinion. Call it John Thain-itis. Many media profiles of hedge fund managers mention private jets, homes in the Hamptons, and flashy lifestyles, none of which has any predictive value about whether a hedge fund is a good investment. It's always been about the returns over a specific period of time, and the comparable risk-reward of other alternatives to invest their money.

Eyeing High-Water Marks

Hedge funds typically have high-water marks, which require hedge fund managers to make their investors whole before paying themselves performance fees. These high-water marks are going to cast a large shadow in the industry for the next few years.

What high-water marks also do—from an investor's perspective—is level the differences between a hedge fund and a mutual fund or other asset manager. Any investor has to pay a percentage of assets in management fees to a money manager. In the case of hedge funds, an investor pays performance fees only when the manager makes money. Investors also know that hedge funds will invariably attract more talent because the compensation levels are higher than the mutual fund industry or elsewhere.

Some observers feel that high-water marks are not the panacea they seem. In a down year, they argue, you can just shut down your fund to avoid the pain of making back past losses and open up another shop across the street. Although this can and does happen, it's just as common for hedge funds to honor their high-water marks instead of taking the easy way out and shutting down, eliminating the high-water mark, and reopening later.

Bottom line: If managers screw up, they need to face the consequences. It's that kind of Darwinism which makes the industry strong. Investors shouldn't have any qualms about having to pay performance—or more correctly stated, revenue-sharing—fees.

Reconciling Differences

With over 10,000 hedge funds worldwide in 2008, funds naturally vary in size and strategy. Some pursue absolute returns, always seeking to grow capital, no matter the market; others aim to beat the S&P or other benchmark on a relative basis. Absolute and relative performance strategies have different levels of volatility due to the different types of risk they take on.

James Simons of Renaissance Technologies recently announced that his firm would not charge fees to existing investors for its Institutional Futures fund, which was down 12% in 2008, but would still charge fees on its Institutional Equities fund, which was down 16%. The difference between the two funds? The first follows an absolute return strategy, while the second aims to beat the S&P 500 by 4% to 6%, which it did.

There is no question that there's a sea change taking place in the hedge fund industry, which saw its assets decline by $782 billion, to $1.21 trillion, in the past year. That's a Detroit-like drop in demand on a year-over-year basis. Within five years, it's likely the mega-funds will dominate, similar to the private equity world, where you have KKR, Bain, T.H. Lee, and a lot of small fry.

Man Group in Britain will be the model for the biggest U.S. hedge funds, running multiple strategies and catering to the institutional investor and pension fund community. It's likely the funds with more than $5 billion in assets today will assume the mega-fund mantle in the future. Funds under that level will shrink or sell out. However, niche hedge funds will continue to thrive, as long as they have unique strategies that are successful.

Most will prosper with a couple hundred million dollars in assets, although some niche strategies can handle up to $2 billion. This is where a lot of innovation and outperformance in the industry will emerge. For example, the most feted hedge fund manager of the past two years is John Paulson, who made billions betting on credit default swaps, which predicted the severe souring of the housing market.

Prior to 2007, Paulson's firm was best known for its unremarkable, yet steady positive returns and merger arbitrage expertise. It's likely that he couldn't have made his bearish housing bet at a bigger shop. The perceived risk he was taking on with the CDS, especially going against the conventional wisdom at the time that housing would rise steadily because it always had in the post-World War II era, would have been rejected. Investors will be always on the lookout for the next great manager whose wave they can ride—and it will come from the smaller, more entrepreneurial managers.

Nothing Personal

Here's a scary thought for hedge fund investors: Hedge funds domiciled offshore (e.g., in the Caymans or British Virgin Islands) have boards of directors that tend, in my experience, to be far more lax and chummy than most corporate boards. (U.S.-based funds typically do not have boards as they operate as general partnerships.) These offshore boards tend to be small, typically two or three people, one of whom is often the hedge fund principal. Since the board oversees the investment manager's mandate, this is a huge conflict of interest that most hedge fund investors don't talk about.

Although it would be wrong to have a large bureaucratic board for a relatively small and entrepreneurial organization like a hedge fund, small boards often encourage managers to ask "friends" to fulfill this role. As a result, board meetings tend to be informal, tough questions don't get asked, and a real debate of legitimate risks facing the fund is avoided.

Many funds end up appointing a "rent-a-director" who lives locally and usually is recommended by, and affiliated with, the offshore lawyer working for the fund. These professional board members often have no job except serving on dozens of similar fund boards. They are simply there to be paid, so they clock in and clock out of meetings with a 9-to-5 mentality that would make a Dilbert character blush.

There are excellent hedge fund directors. However, perhaps not as many funds would be imploding this year had their boards done a better job at holding managers' feet to the fire when times were good.

Slimming Down

The hedge fund industry will be working off its "too big, too fast" growth in the coming years. We're going from 10,000 hedge funds to perhaps 6,000 in the next few months. Performance, operational, and increased regulatory issues will weed out one-third of all hedge funds within two years. Remaining fund managers will have fewer staff, less leverage, and less compensation.

Those hedge fund managers with creative and differentiated strategies (and a track record and a background check that pass due diligence muster) will always find investors. Anyone worth their salt will stick it out; the dead weight and hangers-on will leave. That will make for a better overall industry.

Amid this upheaval and in the wake of the recent Bernard L. Madoff scandal, two hedge fund-related service providers will flourish: (1) third-party administrators who independently calculate a fund's month-end net asset values (NAV) for investors, and (2) third-party due diligence consultants who will scour the backgrounds and documents of fund managers looking for red flags to warn potential investors. I am amazed that these are still not considered absolutely required by investors before making an investment.

Who will wilt: the big fund-of-hedge-funds. Investors want managers who create value. Middlemen who take margin out of the value chain will be forced to defend their existence. Maxxam, Tremont, and Fairfield Greenwich showed us through Madoff that too few funds-of-hedge-funds do meaningful due diligence on their investments that they promised their partners. Funds-of-funds won't die but will drop away in large numbers. Only those that are truly differentiated will survive.

Investors will (and should) place more conditions on fund managers and demand more transparency. Although it will be much easier to do this in a post-Madoff world, an investor's size relative to other investors in a fund will still determine his power to demand this transparency.

Registration Debate

Politicians on both sides of the aisle have called for more oversight on hedge funds, including a suggestion for mandatory "registration." What would registration really accomplish? Many hedge funds will continue to reside outside the U.S. and not need to register. But the largest hedge funds—with a majority of assets—in the U.S. already have registered and file their 13-F list of holdings on a quarterly basis. Registration for registration's sake, giving the government an abundant amount of data to do nothing with, seems a waste of time. Madoff, by the way, was registered with the Securities & Exchange Commission.

If the government wants to help improve capital markets, they should be prosecuting scammers and Ponzi schemes like Madoff, preventing "naked" short-selling abuses, and making it easier for shareholders to oust lazy and nonperforming members of corporate boards.

The hedge fund industry will work out its excesses carried over from the past five years and become a stronger collective of funds and fund managers. Most of the lemmings will leave, until the industry once again begins to experience excessive growth. Oversight must and will improve. Lessons will be learned. And investors will continue to flock to hedge funds because the industry will continue to attract the best managers with the smartest strategies.

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