U.S. hedge funds lick wounds after May market mayhem

BP's failure to stop oil from gushing into the Gulf of Mexico caused tumult in the commodities markets. U.S. securities regulators are still trying to figure out the cause of the May 6 flash crash. And attempts by European governments to allay sovereign debt concerns didn't prevent the Dow Jones industrial average from dropping nearly 8 percent during the month.

Not surprisingly, the $1.6 trillion hedge fund industry suffered along with other investors, with the average portfolio falling 3 percent, according to preliminary data from Bank of America's Merrill Lynch.

Some of the industry's biggest stars -- including John Paulson, Louis Bacon and Steve Cohen -- all were caught flat-footed by the market's tumble, leaving many with losses through May 21, investors in their funds said.

Final tallies for the month just ended are still being compiled, but investors and analysts are certain of one thing -- the news won't be pretty.

The only things that really worked last month were gold, Treasuries and cash, explained Bradley Alford, founder of Alpha Capital Management, which invests in hedge funds. It felt like a repeat of 2008, he added.

Hedge funds are not required to disclose their performance numbers publicly, so any snippets about how the industry's biggest funds performed are watched closely.

Already last week David Tepper, whose Appaloosa Management gained 130 percent last year on bets that ailing financial stocks would recover, gave a hint of how his fund suffered.

We are a $13 billion hedge fund, Tepper said at the Ira Sohn Conference, where some of the best-performing managers describe their best ideas. At the start of the month we were a $14 billion hedge fund. But what the hell. What are you going to do?

At the end of the first quarter, Tepper had invested nearly three-quarters of the fund's assets in financial stocks like Bank of America Corp , Wells Fargo & Co , and Citigroup Inc , which suffered heavily during the banks' sell-off last month.

Other big managers who also gorged on bank stocks early in 2010 now may be dealing with similar cases of indigestion.

In the first three weeks of May, Paulson's Advantage fund fell 6.9 percent, a person familiar with its performance said. During the three months of the year, Paulson, whose prescient bet against the U.S. housing market three years earned his firm $15 billion, had raised his holdings of Bank of America, according to government filings.

As a group, so-called long/short hedge funds were the industry's worst performers, dropping 5.13 percent, analysts at Merrill Lynch said. And funds that pursue a global macro strategy through big bets on currencies and interest rates, for example, were seen off 1.5 percent through last Thursday, according to Hedge Fund Research, an industry tracking firm.

Investors are saying that some of these types of funds were hurt badly on the currency trade and then raced to cover long-standing bets that the dollar would sink when the euro began falling fast. For example, Louis Moore Bacon, who runs Moore Capital Management, lost 7.7 percent in his Moore Global fund during the first three weeks of May, an investor said.

To explain markets that befuddled even the industry's most sophisticated investors, some took the unusual step of acknowledging where they goofed.

Managers at Scottwood Capital, hedge fund run by Edward Perlman that specializes in distressed debt investing, told investors in a rare letter: We are not in the habit of discussing in writing our results during the month, but given the aberrational circumstances of May, we feel that it is not only appropriate but essential.

A Scottwood employee confirmed that the Greenwich, Connecticut-based company had sent the letter to clients. A copy was published on the closely watched industry website Dealbreaker.com.

Our exposures were simply too high, regardless of the soundness of our investment rationale and the high levels of our conviction, the firm wrote. ... Being right on the way up cannot be viewed in and of itself as mitigating the inevitable risks inherent in having overly concentrated positions. They did not say how much money they lost in May.

(Reporting by Svea Herbst-Bayliss; Additional reporting by Laurence Fletcher in London; Editing by Richard Chang)