If you could pick anyone in the world to give you financial advice, John Paulson would surely be on your short list. He is reputed to have personally made over $5 billion in 2010. He had the foresight to bet against risky mortgage derivatives in 2010, which earned him over $4 billion. More recently, he profited from investing in gold, which he predicted will reach $4,000.
I’ll bet you regret not being in Paulson’s Advantage Plus Fund. If you were, you would get the benefit of investment advice from this master stock guru. But, given his stellar record, it may be surprising that the Advantage Plus Fund is down almost 40 percent for the year to date. In August, 2011 alone the fund lost almost 22 percent.
This poor performance is not a one-off. Another Paulson fund, Paulson Partners, is down almost 12 percent for the year. Last quarter, Paulson dumped his holdings in Bank of America at a loss, reducing the profits he could have made from Warren Buffett’s recently announced $5 billion investment in the bank. By some accounts, the sale of these shares cost Paulson over $52 million of additional profits.
What’s going on? How could an investor as shrewd as Paulson make all these rookie investing mistakes? Paulson’s uneven performance is fully consistent with data tracking the performance of other hot fund managers. Here are a few representative examples:
- The Direxion Monthly Commodity Bull 2X Fund ranked number 1 in 2007. In 2008, the fund ranked 7,121.
- In 2006, the top ranking fund was the Dreyfus Premium Greater China A Fund, run by two managers. It finished 16 in 2007 and then dropped to 6,960 in 2008.
- ProFunds UltraJapan Investor A Fund, run by a quartet of skilled managers, was number 1 in 2005, 2,320 in 2006, 6,744 in 2007, and 7,106 in 2008.
When a fund manager is hot, it’s more often than not a function of luck and not skill. Skill persists. Luck doesn’t. Wall Street’s expertise is in confusing luck with skill. A top performing fund manager is extolled as a stock market guru until he falters. Then a new one emerges and the process repeats itself.
The next time you are tempted to place a bet on a hot fund manager, remember this: John Paulson is probably smarter than 99 percent of fund managers. His investors are down 40 percent this year. After taxes, expenses, and trading costs, the odds of an actively managed fund beating its index over the long term are close to zero. Dump your actively managed funds and invest in a risk adjusted, globally diversified portfolio of low management fee index funds.
Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, will be released in September, 2011.