The Paulson & Co Advantage fund is making money for the year, but just barely, with a 1.3 percent gain, the source said.
The fund's substantial holdings in several gold mining stocks, including a bet on AngloGold Ashanti Ltd, which is down 40 percent this year, have dramatically cut into the Advantage fund's returns.
Gold is one of the worst performing assets this year after rising mightily following the financial crisis. The precious metal has fallen 17 percent this year, including a 13 percent drop in April alone.
Shares of companies tied to the performance of gold, including the SPDR Gold Trust, the biggest gold exchange-traded fund, also have fallen sharply. This year investors have pulled $10 billion out of the gold ETF as of Wednesday, said financial information firm Markit.
The sharp slide appears to have caught a number of hedge fund managers like Paulson by surprise. Next week he intends to update his clients about all of his funds, including a fund dedicated specifically to investing in gold, several sources said.
Paulson, who has made money on gold up until this year, has long held firm to the view that inflation will eventually rebound, making gold a prudent hedge. But in the wake of the selloff, the firm has incurred losses in the hundreds of millions of dollars in several funds that invest in gold, said people familiar with the firm.
The fund manager, lionized after a big bet against the overheated housing market in 2007 that made billions for his investors, has floundered trying to repeat the success in recent years.
Assets at his firm have dropped to $18 billion down from $38 billion in early 2011 due to redemptions and poor performance. Over the past two years, the Advantage fund and a leveraged version of the fund have posted some of the worst numbers in the $2.2 trillion hedge fund industry.
At the end of the first quarter, the Advantage strategy, which includes the two funds and managed accounts, had about $4.6 billion in assets.
STICKING WITH GOLD
Still, Paulson is sticking with his plan. "The recent decline in gold prices has not changed our intermediate- to long-term thesis," Paulson partner John Reade said earlier this week.
A Paulson spokesman would not comment on the April numbers for the Advantage Fund.
For the New York-based fund manager, gold's drop is another in a string of black eyes. He has also taken heavy losses on some big investments, including in Chinese forestry company Sino-Forest Corp and Bank of America Corp. In 2011, the Advantage Fund's sister fund, Advantage Plus, lost more than half of its value.
The Advantage Fund's performance this year also leaves Paulson near the bottom of the rankings. Some hedge fund managers are reporting double-digit gains, but most were up only 3 percent in the first quarter. The Standard & Poor's 500 index was up 10 percent.
Paulson's fund is not alone in holding fast to the notion that gold is still an asset to hold.
In a research note this week, Ray Dalio's $141 billion Bridgewater Associates wrote that while the magnitude of the selling in gold was surprising, much of it was driven by selling by "weak" and leveraged hands.
However, several investment banks beginning with Goldman Sachs cut their 2013 gold price forecasts over the past two weeks. Any fund that uses technical analysis to buy and sell securities is selling gold now, a Wall Street analyst who was not authorized to speak publicly said.
Other investors say some hedge fund managers have lost a lot of money on gold because they did not hedge the bet properly. "Most people who are long gold are only long," said John Burbank, who runs hedge fund Passport Capital. He said his own fund hedged by owning physical gold and betting against gold mining companies, whose share prices have dropped dramatically.
Burbank said his company employs two geologists to dig deeply into the gold mining companies. "Other firms don't have that," he said.
In addition to Paulson, other well-known hedge fund managers David Einhorn and Daniel Loeb are also victims of the recent gold rout.
Loeb said gold was one of his Third Point hedge fund's biggest losers in the first quarter in a recent investor letter. Einhorn's Greenlight Capital Management recently listed gold as one of his five largest positions. He is believed to largely own physical gold as opposed to shares in the exchange-traded fund.
Any hedge fund with large gold positions, whether in its physical form or through equities, is being hurt, said the Wall Street analyst.
Other investors had better timing and slashed gold investments before the metal began to nosedive this year. Billionaire George Soros significantly reduced his gold exposure in the fourth quarter of last year, for example, and recently said the asset was "destroyed as a safe haven".
Hedge funds Moore Capital Management and Lone Pine both got rid of stakes in the SPDR Gold Trust ETF at the end of the year, regulatory filings show.
(Reporting By Svea Herbst-Bayliss and Katya Wachtel; Editing by Matthew Goldstein, Kenneth Barry, John Wallace and Tim Dobbyn)
By Svea Herbst-Bayliss and Katya Wachtel