By Katherine Burton

March 29 (Bloomberg) — John Paulsonstarted the year overseeing $32 billion in hedge funds, third in the world behind JPMorgan Chase & Co. and Bridgewater Associates LP. Unlike many of his biggest rivals, he’s taking in new cash, raising the question of how much money is too much for a hedge-fund manager.
“There’s no doubt that Paulson is a big draw for investors at the moment,” saidRichard Tomlinson, founder of London-based Tomlinson Investment Consulting, which advises clients on hedge funds. “As with all managers that bulk up, there’s always the risk of returns becoming mediocre.”
Paulson & Co., the New York-based firm that the former Bear Stearns banker and Gruss Partners trader started in 1994, differs from many large competitors because it makes concentrated bets, such as the wager against subprime mortgages that helped generate $3 billion of profit in 2007. As assets increase, it can get harder for a fund to find investments big enough to drive returns and to trade without distorting prices.
Paulson’s main $19 billion Advantage funds, which primarily seek to profit on distressed debt, bankruptcies and mergers, have lagged behind peers this year and last after beating them in 2007 and 2008. Armel Leslie, a spokesman for Paulson, declined to comment.
Lessons of Tiger
The world’s largest hedge funds are approaching their previous peak assets after recovering from their worst-ever losses and investor outflows in 2008. They are benefiting from a shift by pension funds and endowments to established firms with steady returns and staff dedicated to risk management.
Fourteen firms managed $20 billion or more in hedge funds at the start of 2010, when industry assets stood at $1.6 trillion. Hedge funds oversaw a record $1.9 trillion in mid- 2008.
In 1998, only George Soros’s Soros Fund Management LLC and Julian Robertson’s Tiger Management LLC exceeded the $20 billion mark. Within two years of hitting that milestone, both firms had suffered big losses and decided to stop managing money for other investors.
“There is a point where you can be too big to generate returns,” saidLawrence P. Chiarello, a partner at Red Bank, New Jersey-based SkyView Investment Advisors LLC, which selects hedge funds for clients. “Being large and able to build a strong infrastructure are good things, but in general I think the pendulum has swung too far.”
The size at which a fund may become too big depends on factors such as its investment strategy and the markets in which it trades, Chiarello said.
Citadel’s Stumble
The industry is replete with examples of managers losing billions after they took increasingly bigger bets to produce top returns. Robertson’s fund was brought down in part by a 25 percent stake in US Airways Group Inc. and $2 billion of losses when the U.S. dollar fell against the Japanese yen.
In 2008, Chicago-based Citadel Investment Group LLC, whose assets had climbed to about $20 billion, lost 55 percent in its biggest funds after wagers on convertible, high-yield and investment-grade bonds hedged with credit-default swaps all went awry. It managed about $12 billion at Dec. 31.
Hany Shawky, a finance professor at the University of Albany-State University of New York, wrote a paper in 2008 that found that smaller funds outperform larger funds on an absolute basis. On a risk-adjusted basis, which takes into account the swings in returns, large funds were better. Shawky is working on an update to his study, which he said has found similar results.
Smaller Bets
While New York-based JPMorgan and Bridgewater of Westport, Connecticut, are larger than Paulson’s firm, they tend to make comparatively smaller bets.
JPMorgan manages about $33 billion in more than 50 funds in markets around the globe. The bank’s wholly owned Highbridge Capital Management LLC subsidiary manages an additional $11 billion in four funds.
Bridgewater manages its $43.6 billion in one strategy it calls Pure Alpha. The firm takes many small positions using futures to bet on stock indexes, bonds, currencies and commodities. Those markets are liquid, meaning that traders can get in and out of positions without moving prices dramatically.
Paulson tends to invest a lot in trends he has identified.
In 2007, before the housing market collapsed, he spent $2 billion buying credit-default swaps on subprime mortgages, a trade that soared when home loans went bad in record numbers. Today he has 10 percent to 15 percent of his Advantage funds in the shares of gold-mining companies on the expectation that prices of the metal will rise along with inflation.
Housing Score
The subprime wager paid off. The Advantage Plus fund, which uses leverage to amplify returns, jumped 160 percent in 2007 and 37 percent in 2008. Comparable funds gained an average of 6.6 percent in 2007 and fell 22 percent in 2008, according to Chicago-based Hedge Fund Research Inc. The firm’s Credit Opportunities funds, which held the biggest chunk of Paulson’s subprime trade, were up 600 percent in 2007.
Paulson’s performance was more pedestrian in 2009. The Advantage Plus fund climbed 21 percent, compared with about 25 percent for peers. Through February 2010, it lost 1 percent, compared with a gain of 1 percent for similar funds.
Even as performance trailed peers last year, the Advantage funds increased the amount of borrowed money they used. In June, the funds had borrowed 34 cents for every dollar of net assets, according to a presentation Paulson made at a Merrill Lynch & Co. investor conference in February. The level climbed to 50 cents for every dollar by December.
Some Paulson investors say they aren’t concerned that he’s gotten too big.
Bigger Not Bad
“For funds that invest in a number of strategies, size isn’t an issue,” said Brad Alford, head of Atlanta-based Alpha Capital Management LLC, which picks hedge funds for clients and is a Paulson investor. “Bigger funds produce more in revenue, so they can hire the best talent and build the most robust infrastructure.”
Paulson, 54, started his hedge-fund career 16 years ago with a fund that focused on merger arbitrage. In 2004, when he was managing $3 billion, he began expanding, adding the first Advantage fund. He opened his first credit fund in 2006. At the end of 2008, he started the Recovery Fund, now $1.7 billion, to bet on companies like Citigroup Inc., Conseco Inc. and Bank of America Corp. as they rebounded from the financial-services meltdown.
This year he launched a $350 million gold fund and a real estate fund that is buying property at distressed prices.
At the Merrill Lynch investor conference, Paulson defended the size of his firm as he closes in on the $36 billion in assets he reached in 2008.
Marketing Continues
“Paulson funds tiny relative to market opportunities,” was the title of one slide. It compared the $6.9 billion Credit funds to the markets for distressed mortgages, high-yield bonds and leveraged loans, saying each are more than $1 trillion.
Paulson continues to market his funds because he sees opportunities in the next 18 months to 24 months as companies restructure their debt, said Charles Krusen, head of New York- based Krusen Capital Management LLC and a Paulson investor.
The unleveraged version of the Advantage fund is targeting returns of 12 percent to 15 percent, he said.
“We think they’ll be able to do that,” said Krusen, adding that Paulson has closed his credit and merger-arbitrage funds before when he was concerned their size might hinder performance.
Brevan Howard Asset Management LLP, Europe’s largest hedge- fund firm, closed its $2 billion Asia Fund and $2.5 billion Emerging Market Strategies Fund to new investors last November, and is limiting inflows into its $21.3 billion Brevan Howard Master Fund Ltd.
Tudor, Shumway
Paul Jones’s Tudor Investment Corp. has stopped taking money into its $9.5 billion BVI Global Fund Ltd. Jones also returned some of 2009 profits in the Greenwich, Connecticut- based fund to clients this year as another way to cap assets.
Chris Shumway, who runs Greenwich, Connecticut-based Shumway Capital Partners LLC, a stock hedge fund, isn’t accepting more money after reaching $8 billion. New York-based King Street Capital Management LP, a credit fund, told investors it would “moderate” growth now that it has more than $20 billion, according to a letter sent to investors.
“Three of our core managers have closed to new investments,” said Stewart Massey, who runs Massey Quick & Co., a consulting firm in Morristown, New Jersey, that caters to wealthy individuals, endowments and foundations. “We love to see that. What they are saying is, ‘I’m running this for performance, not scale.’ ”

Hedge-Fund Firms With $20 Billion or More in Assets
(Jan. 1, 2010)

JPMorgan Chase & Co. $44 billion
JPMorgan Asset Management $33 billion
Highbridge Capital Management $11 billion

Bridgewater Associates $43.6 billion
Paulson & Co. $32 billion
Soros Fund Management $27 billion
Brevan Howard Asset Management $27 billion
Man Group $25.3 billion
D.E. Shaw $23.6 billion
Och-Ziff Capital Management $23.5 billion
Baupost Group $21.8 billion
Angelo, Gordon & Co. $20.8 billion
Goldman Sachs Asset Management $20.8 billion
Farallon Capital Management $20.7 billion
Avenue Capital Group $20 billion
King Street Capital Management* $20 billion

*As of Feb. 28, 2010.
Source: AR magazine, Pensions & Investments magazine and
Bloomberg data.
To contact the reporter on this story: Katherine Burton in New York

Last Updated: March 29, 2010 11:43 EDT