Last January, when investors in one of Paulson & Co.'s best-known hedge funds saw the value of their investments had been slashed in half, some wondered how much worse it could get.
Then by Sept. 30, there was an additional drop of 15 percentage points—with three months left to go in the year.
As a result, some Paulson investors—who gave the firm a pass last year when the riskier version of the firm's umbrella fund, Paulson Advantage Plus, saw enormous losses—are now throwing in the towel.
Fed up with lagging returns at the hedge-fund management company, a number of investors large and small are opting to either reduce their capital at risk or yank it entirely by year's end.
It's the latest blow to fund manager John Paulson, who became famous in the investing world after he bet correctly on the collapse of housing prices in 2008.
"We expected, based on the way [Paulson] does things, that we're going to have periods of time where he's out of favor," said Craig Husting, the chief investment officer of the Public School and Education Employee Retirement Systems of Missouri, a pair of pension funds that have trimmed their investments in Paulson's Advantage Plus to a third of the original size over the past year and a half. "But just the beta — the volatility of his bets — is why we pared back."
With just days to go before an Oct. 31 deadline for investors who want to redeem their capital to notify Paulson, Husting may well be joined by a panoply of others.
They range from the private bank of of Citigroup, which revealed in August that it would claw back its funds (a process starting in 2013), to the 92nd Street Y, which people familiar with the matter said pulled its capital this year because of concerns about future potential losses and its investment mix.
Other significant players, including the brokerage arm of Morgan Stanley, are considering pulling funds, but haven't yet made a final decision, people familiar with the matter said. (A spokeswoman for the 92nd Street Y didn't return calls for comment, and a Morgan Stanley spokesman declined to comment.)
Paulson, which is known for its aggressive, 25-person investor-relations team, isn't taking the reversals lying down.
"Recent performance in our Advantage Fund is disappointing and we understand investor frustration," said the firm in a written statement.
The firm noted that over the lifetime of the Advantage Funds, which were opened in 2004, Paulson had "far exceeded" both the event-driven hedge fund index and the Standard & Poor's 500-stock index, returning more than 10 percent annually.
It also noted that only a small fraction of its total assets under management is invested in the two Advantage funds in dollars. Investors who convert their capital in to gold shares, an option available to all Paulson investors in all funds, are actually flat for the year in the Advantage Fund, the firm added, not down. (Those in the Advantage Plus Fund via dollars are down 6 percent.)
During the past year, Paulson has worked to appease worried investors.
Last winter, the company invited unhappy Advantage fund participants to move their capital into other Paulson funds while preserving their high-water marks. That meant that the former Advantage investors had the chance to participate in 100 percent of their new funds' profits, rather than the standard 80 percent, with the remaining 20 percent reverting back to Paulson management.
At the same time, Paulson set up a new risk-management structure that gathered for biweekly meetings and set new trading and leverage limits.
Ironically, though, it was some of the resultant hedges against a further credit crisis in Europe, as well as battered performances in Paulson's gold-miner portfolio, that have given the firm's Advantage funds trouble since.
Through Sept. 30, people familiar with the matter said, the Advantage Plus fund has fallen 15 percent, meaning that a dollar invested in it on Jan. 1, 2011, would be worth about 41 cents today. In the Advantage fund, the drop was roughly 10 percent, meaning that that dollar would be worth 57 cents today.
That fall has been equally pronounced in the firm's total assets under management.
Once $38 billion, the figure has fallen to nearly half that since early 2011, and now sits at nearly $20 billion, people familiar with the matter said.
Of that, about $12 billion belongs to John Paulson and his employees, creating what the firm described in its statement as "a very sticky capital base."
The firm also points out that on a capital-weighted basis, its funds are up an average of 2 percent this year.
Heartened by Paulson's tremendous wins during the recession and hoping 2011 was a one-off, many investors hung tight over the past year.
But an August announcement that Citigroup would remove Paulson from its internal hedge-fund platform, which initiated a $410 million redemption process, crystallized the doubts among some of the fund company's more patient investors.
"In my 20-plus years, I have never seen someone go from so high to so low in such a time period," said Brad Alford, who runs the Atlanta investment firm Alpha Capital Management and had originally invested about $10 million of his high net worth clients' money in Paulson. That figure, Alford estimated, is now closer to $3 million.
His frustration with Paulson is such that he's pulling out of a broader fund-of-funds platform entirely just to remove his capital from Paulson — even though the platform contains other funds he likes, such as DE Shaw's Oculus Fund, which is up by double digits so far this year.
"You just get so frustrated that you are done with the name, you are done with the manager, he's done something you can never go back from," Alford added. He's had better luck with mutual funds that employ hedge fund-type strategies with much more liquidity and a fraction of the fees, he said.
Correction: An earlier version of this story misstated the proportion of Paulson Advantage fund participants who were invested in those funds through gold shares.
—By CNBC's Kate Kelly; Follow Her on Twitter @KateKellyCNBC