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September 13, 2006

Goldman Sachs Hedge Fund Blows Up - Down 10% in August

posted by MR WAVETHEORY at 9/13/2006 02:38:00 AM

A few months ago, the Economist wrote a glowing article about Goldman Sachs, ironically entitled Goldman Sachs, On Top of the World, which also hinted that the extreme profitability of its hedge fund/proprietary trading business also posed extreme risks. Goldman Sachs is on top no more.

It seems like the Economist was prescient in calling for a blowup at Goldman Sachs Group, Inc. The WSJ writes that
Goldman's Global Alpha fund, managing $10 billion, lost 10% of its value in August. To put that into perspective, the average hedge fund is expected to generate 10-20% returns per year. It looks like there won't be fat bonuses this year for the hedge fund guys - and perhaps even some layoffs!

What is interesting is that Goldman did very poorly in August when hedge funds as a whole did well:

"Unfortunately, many of our strategies underperformed in August, in particular those strategies to which we have allocated most of our risk," the preliminary draft of a letter to investors says. "There was no particular strategy of outsized magnitude that alone drove poor performance." The letter's estimates
were calculated on estimates as of Sept. 7.

By contrast, last month was generally positive for the hedge-fund industry as a whole (though the year has been lackluster for funds like these). When the Federal Reserve paused in early
August after 17 consecutive interest-rate rises, both the bond market and the stock market rallied in relief. For example, the Hedge Fund Research composite index for August was up 1.14%.


Perhaps Goldman was trading/taking bets against its customers? It appears so. Bonds rallied in August because of the pause in rate hikes. How did Goldman lose so much money? Goldman Sachs took the wrong bet. Goldman Sachs was short bonds.

Goldman was hurt by negative bets on both Japanese Government bonds and 10-year U.S. treasuries at a time when both rallied, according to the letter. The Alpha fund also lost money in other global bond markets by betting price would fall
when in fact that rose. The Alpha fund also bet that the New Zealand dollar would fall against the U.S. dollar, but instead it rose by 6%.

Goldman Sachs's blowup is a perfect example of long tail risk. It is easy to get lulled into thinking that generating small, smooth incremental returns is easy - until the big one hits.

The fund has rarely turned in monthly performance as bad as the recent numbers. One came in October 1998, when the fund dropped 10.5% on a net basis.


By the way, Goldman Sachs hasn't reversed its position due to the blowup. It intends to stay the course with its short bond position.

Global Alpha told investors it doesn't intend to change course. "Our overall view on U.S. Treasuries was and continues to be negative given poor long-term value and a less favorable macroeconomic outlook," the letter says. "We still have a negative overall view" on Japanese debt, and in general the fund says it considers "global bonds to be expensive."

If you're a hedge fund managers, keep buying bonds and keep squeezing the shorts! It is starting to sound like another Long Term Capital Management.

Link: Goldman Sachs Conference Call Transcript
Related Link: Hedge Funds Miss Their Target

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