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Citi will redeem from the flagship Advantage portfolios, which have recorded double-digit losses so far this year, as well as the Merger and Recovery funds, which have made gains in 2012.
The bank discussed its plan to withdraw from Paulson's fund on a Thursday morning call with its private bank advisers, said one of the people familiar with the decision, but who was not on the call.
The Advantage Plus fund sank 18 percent through the end of last month, and the Advantage fund declined 13 percent over the same period.
Hedge funds gained 2.88 percent on average through July 31, according to hedge fund tracking firm HFR, while the broader stock market rose 7.41 percent over the same period.
Armel Leslie, a spokesman for Paulson & Co, declined to comment on the withdrawal. Citi, a unit of Citigroup Inc, declined to comment.
The redemption was first reported by Bloomberg.
The sources who spoke to Reuters requested anonymity because they were not authorized to speak publicly on the details of the redemption.
As returns faltered earlier in 2012, Citi put the Paulson hedge funds on a so-called watch list, a source said. It was not the only bank platform invested with the $19.5 billion fund that showed signs of cold feet. The brokerage arm of Morgan Stanley also placed Paulson on a "watch list" early in the second quarter, instructing clients to avoid putting new money with him.
Paulson's New York-based hedge fund is one of the $2 trillion hedge fund industry's most closely followed names. He rose to prominence after incredibly lucrative and successful bets on the sub-prime mortgage crisis and gold, which earned him billions of dollars.
But an ill-timed bet on a U.S. economic recovery had disastrous consequences for the once high-flying fund. His Advantage Plus fund ended 2011 down roughly 52 percent, while the unleveraged version of that fund, the Advantage Fund, fell 36 percent.
Paulson told investors in the beginning of this year that last year's losses were an "aberration." But he has struggled to right the ship in 2012, with those funds seeing more double-digit losses this year. Other portfolios of Paulson's have performed better, however, with the Paulson Recovery Fund gaining 3.9 percent in the first seven months of the year, and the merger arbitrage fund rising 5.4 percent over the same period.
In the first quarter, New Mexico's $11.9 billion state pension fund withdrew its $40 million investment from the hedge fund. Joelle Mevi, the state's chief investment officer, told Reuters that the pension fund had concerns that Paulson's fund had become too large and could not easily get in and out of positions.
Other institutional investors, like the $30 billion Missouri Public Employee Retirement System, have remained committed to Paulson & Co, despite the poor returns in the Advantage portfolios.
More than half of the capital in Paulson & Co belongs to its partners.
(Reporting by Katya Wachtel; Editing by Matthew Lewis and Tim Dobbyn)
By Katya Wachtel
