THE BLOG
01/29/2011 06:26 am ET | Updated May 25, 2011

How John Paulson Made $5 Billion Last Year

The secret to the spectacular returns Paulson and his employees reported for 2010 is due to their keeping much of their money- $14.9 billion or 42% of the total assets under management($35 billion)-- in the funds. That's called putting your money to work alongside your clients. That $14.9 billion commitment is revealed in Paulson's yearend letter to investors.

Some of Paulson's personal share in his funds must come from reinvesting the $4 billion he made going short against the subprime mortgage bubble in 2007.

The Paulson funds made gross gains in 2010 of $8.4 billion before fees. So, 42% (their share) of the $8.4 billion meant $3.5 billion in gains for Paulson and his employees.

Add to that a 2% fee on $20 billion of capital from investors-- $400 million-- and then the 20% fee on the total profits made adds another $1.7 billion to the pot shared by Paulson and his team.

By my figuring then, the total take comes to roughly $6 billion before taxes.

Overall, the fund's strategy made a transition during the year from a short equity bias with a focus on being long distressed securities to a long equity event focus, according to Paulson's year-end letter.

This growing bullishness on the stock market is due to Paulson's careful tracking of the equity risk premium measured by J.P. Morgan; the difference between the yield on equities and the yield on bonds. At present, the yield on stocks, the obverse of the price-earnings multiple, is 7-8%-- while the yield on 10 year treasuries is only 3.34%. In this comparison the potential return on stocks is double the return on bonds.

Paulson is a buyer of stocks because he sees the equity risk premium in the market as "the highest it has been in over 50 years., indicating to us that equities are due to rise as the current economic environment is by no means the most challenging it has been in 50 years," he wrote in his yearend letter which was posted Friday on the internet.

Last year, for example, Paulson made a 43% return or over $1 billion on Citigroup-- buying shares at $3.20 a share and selling them for $4.60 a share later in the year.

The Paulson Gold Fund was up over 35% on the year, as positions in Anglo Gold, Osisko and GLD, the giant gold ETF all paid off bigtime. Paulson is optimistic that gold will outperform for the next 5 years and is "the ideal vehicle to hedge against the risk of the U.S. dollar."

The funds held $20 billion in 40 different distressed situations where most of the companies have "repaired their capital structures."

He also sold off positions in major banks like Bank of America, and went long Anadarko, the oil and natural gas producer.

Paulson's hedge fund has piled up gains of 26 billion since inception in 1994-- 3rd biggest killing of all hedge funds. Quantum Endowment Fund, begun by George Soros in 1973, has racked up $32 billion in net gains. Renaissance Medallion Fund, founded in 1982 by James Simons, has delivered net gains of $28 billion.

He expects all his funds "to outperform in 2011."