For years, Goldman Sachs’s asset management business has been the envy of Wall Street. While other investment banks have struggled to establish a hedge fund arm, Goldman has raced ahead. At the end of May, it had $151bn of alternative assets, making it one of the world’s largest hedge fund managers.
In the past week, however, Goldman learned that being a big hedge fund manager can be a mixed blessing when wild swings in the global markets undermined some of its high-profile quantitative funds. Its Global Equity Opportunities fund suffered such heavy losses that Goldman on Monday took the unprecedented step of putting $2bn of its own capital in the fund.
Goldman is the most high-profile victim of the recent upset in quantitative strategies: the fund management style that uses sophisticated computer models to spot opportunities to buy and sell securities, sometimes exploiting very small price differences. The funds then use leverage in order to amplify their potential returns.
These funds, which are typically sold to institutional investors and wealthy individuals, have proved profitable in recent years. Last week, however, things began to go drastically wrong in the sub-set of quantitative funds that specialise in equities.
For reasons that are still unclear, shares began to move in ways that were the opposite of those predicted by computer models. These moves triggered selling by the funds as they attempted to cover their losses and meet margin calls from banks. This in turn exacerbated the share price movements.
The effect was dramatic. At the beginning of last week, the GEO fund was down a few percentage points from the beginning of the year. By Friday it had lost more than 30 per cent of its value. Goldman’s flagship Global Alpha fund, which uses quantitative strategies across a range of asset classes, has lost 27 per cent of its value this year.
“We were seeing things that were 25-standard deviation moves, several days in a row,” said David Viniar, Goldman’s chief financial officer. “There have been issues in some of the other quantitative spaces. But nothing like what we saw last week.”
Faced with this situation, Goldman had to make a decision. If the bank did nothing, the GEO fund would probably be hit with large-scale redemptions in the next few weeks as investors pulled out what money they had left, triggering further selling by the fund.
But Goldman came up with an alternative: it would commit $2bn of its own capital in an effort to shore up confidence and to allow the GEO fund to ride through the downturn. It also asked some clients to join in. A handful of investors with strong links to Goldman, including C.V. Starr, the investment vehicle run by former AIG chairman and chief executive Hank Greenberg; Perry Capital, the hedge fund managed by a former Goldman Sachs trader; and Eli Broad, the real estate and insurance entrepreneur, chipped in another $1bn. Goldman yesterday denied that the move was a bail-out, arguing that it decided the GEO fund’s portfolio represented a good investment.
“We do not want to leave the impression that we have some moral or other obligation to shore up a fund. People who invest in a fund know what they’re investing in,” Mr Viniar said.
However, observers said the failure of such a large fund would have been a huge embarrassment to Goldman, which enjoys a reputation for savvy. Among the losers would have been Goldman partners, a significant number of which are thought to have been investors in the fund.
Goldman’s investment on Monday appeared to have had the desired effect, boosting some shares in which its fund had invested and also reviving the investment bank’s share price, which had fallen sharply.
The bank also attempted to play down concerns that it might be facing similar losses on its own balance sheet as a result of proprietary trading bets. Mr Viniar said that, while Goldman does use its own balance sheet to pursue quantitative strategies, its exposure was “quite small”.
A broader question, however, is what damage the events of the past week mean for quantitative strategies. Mr Viniar said he believed the investment style would recover, but that the bank would take a more robust approach when considering the potential downside in strategies that have a wide following.
“What we have to look at more closely is the phenomenon of the crowded trade overwhelming market fundamentals,” he said. “It makes you reassess how big the extreme moves can be.”
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