John Paulson’s most famous bets are the ones with an apocalyptic tint. His “big short” on the US housing market catapulted his eponymous hedge fund into the big league in 2007, and he has subsequently gambled that the price of gold will skyrocket in an era of central bank money-printing (well, you cannot win them all). This year, though, some of Paulson & Co’s best returns are coming from a rosier bet. Specifically, his $2.3bn Recovery funds have gained a tasty 40 per cent since the start of 2013, thanks to investments in banks, insurers and – less well publicised – asset managers.
It is a simple thesis, widely shared, and one that has proved lucrative in past cycles: asset managers offer a leveraged play on a rising equity market. When assets increase in value, it boosts the cut managers take in fees, while the sight of rising markets lures investors back to their brokers’ offices; a virtuous circle. Except that some asset managers are more leveraged to rising equity markets than others, and almost all of them will benefit less in this upturn than they have previously. Mr Paulson is hardly taking a scattershot approach. According to its most recent letter to investors in the Recovery funds, seen by the Financial Times, Paulson & Co has honed in on private equity managers as a preference, specifically Blackstone and Apollo Global Management. One of the main reasons is that private equity managers are once again able to charge performance fees on top of regular management fees, now that funds have recovered recession-era losses. “Asset management companies such as Blackstone are ideal Recovery fund investments because of the correlation between economic growth and increases in realised performance fees, which are up 800 per cent over the past two years,” the letter says. Equally important, private equity firms also invest their own money. They benefit from a valuation uplift in their portfolio and from the renewed appetite for initial public offerings, another byproduct of rising equity markets, which allows them to cash in previous deals. Apollo has been the most active in realising profits on its private equity investments, bringing in $10bn this year through deals including the flotations of Evertec, the Caribbean payments processor, and Constellium, the aluminium products group. Paulson & Co refused to comment on the size of its positions in Blackstone and Apollo, which have not been disclosed in regulatory filings and therefore may have been made indirectly through instruments other than the companies’ equity. The major private equity firms were not listed companies when global markets were recovering from the recession in the early 2000s. More highly leveraged to the rising equity market than those of traditional managers, their shares provide an alternative to the asset management stocks that were available to investors who wanted to make this trade during the last upturn. Yet almost every shade of firm in the sector has been in demand as the S&P 500 has surged. Most hit record highs last year or earlier this year and kept on going. The broad sector rally comes despite mixed operating performances by the big global managers, and some downright disappointing figures in the recent set of quarterly earnings. Firms such as Federated Investors and Franklin Resources, whose strongest businesses are money market funds and fixed income investing, respectively, were among those to record outflows in the third quarter. But while bond businesses were as bad as predicted, given market volatility and fears of a turn in interest rates, equity businesses were not nearly as good as expected as a counterpoint. Active equity management, it seems, is simply not going to rebound as sharply in this cycle as previously. T Rowe Price blamed outflows on a few big institutional clients turning more cautious on the markets. This could well be the start of another worrying trend: institutions who were forced into equities, because the low yields on fixed income would leave them hopelessly underfunded, might return to their comfort zone in bonds in a higher-rate environment. But the main culprit is the secular shift from active to passive management. Inflows boosted assets under management at BlackRock’s iShares exchange traded equity funds by 3.6 per cent in the third quarter, compared with a meagre 0.7 per cent into actively managed retail equity funds. On the institutional side of its business, cheaper passive equity products outperformed active, too. The one real winner from earnings season was WisdomTree, the ETF specialist. The asset management sector is a broader and much-altered canvas for stock market investors looking to play this equity market rally, compared to previous cycles. As Mr Paulson has identified, the rising tide will lift some boats higher than ever, but it might not this time lift them all.