How a Goldman hedge fund shrank a third in a week

By Jonathan Keehner - Analysis

NEW YORK (Reuters) - The strategy of using debt like a steroid to boost returns on investments came back to haunt some hedge funds in a big way last week.

That was made clear to investors on Monday when the Goldman Sachs Group (GS.N: Quote, Profile, Research) said two of its hedge funds had sustained losses of about 30 percent.

The so-called quant funds used strategies based on computer models to seize upon market anomalies and boost returns through high leverage, or investing with borrowed money.

"First and foremost, these were all leveraged bets," said S.P. Kothari, a professor at MIT's Sloan School of Management. "If you're leveraged at six times, a loss of 5 percent is magnified into 30 percent. But that's also why some hedge funds have made 100 percent returns."

Goldman's Global Equity Opportunities (GEO) fund -- which last week shed over a third of its value -- employed leverage of about six times equity capital, Goldman Chief Financial Officer David Viniar told analysts on a conference call on Monday.

That fund was left with about $3.6 billion in net asset value after last week's losses, according to Viniar, suggesting the hit to GEO was at least $1.9 billion of a prior net asset value of at least $5.5 billion.

While the loss was humongous, the amount was only about 5 percent of GEO's leveraged market exposure of at least $30 billion.

Goldman and others have since stepped in to inject $3 billion of new equity into the struggling fund. Goldman declined to comment further following the Monday call.