How a Goldman hedge fund shrank a third in a week

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 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.

Leverage was also a big culprit in the recent meltdown of two Bear Stearns Cos BSC.N funds that invested in bonds linked to subprime mortgages.

“Leverage is a double-edged sword,” said Merrill Lynch analyst Richard Bernstein in a research note. “It enhances returns on the upside, but also makes underperformance more rapid and severe.”


Adverse markets can easily cost funds which are as highly leveraged as GEO, one-third of their asset value.

Goldman’s Viniar said last week’s market events were “unprecedented and characterized by remarkable speed and intensity” -- and called stock values “way out of whack.”

Particularly harmful to quant funds at Goldman and elsewhere may have been trading strategies that were governed by similar programs. Those similarities could exacerbate unexpected market turns with a flood of buy or sell orders.

“All these quant funds seem to be running the same core models,” said Brad Alford, a portfolio manager at Alpha Capital Management in Atlanta, whose clients’ investments include hedge funds. “None of them seemed to work when the market had trouble.”

Quant funds were whiplashed by technically driven events last week, putting them on the wrong side of a series of market bets, experts said.

Early in the week equities rallied when short sellers covered their positions, a fund manager said, while later in the week some stocks fell as funds sold off liquid positions to build cash reserves.

“Models were telling them to do one thing and for several days in a row they should have pretty much done the opposite,” the manager added, asking to remain anonymous.


So far hedge fund losses have been showcased through disclosures by public companies like Goldman or Bear Stearns.

But these funds are subject to more disclosure regulations than those managed by private companies, meaning similar losses in private funds may not yet be visible to the public.

Indeed, the $26 billion-plus Renaissance Institutional Equities Fund, managed by quantitative trading pioneer Renaissance Technologies Corp, was down about 7 percent as of last week.

“I don’t think the losses here are the result of a few funds making unusually large bets,” said MIT’s Kothari. “It’s across the board.”

Additional reporting by Dan Wilchins