Wednesday, August 15, 2007

When the Gamma of the Beta Begins to Lose its Alpha

"No, let me just clarify. This is not a rescue. This is two things. First, given the dislocation in the markets, we believe that this is a good investment opportunity for us and the other investors that we have brought in. We also think at the same time this will be very helpful to the current fund investors because it will give the fund the wherewithal to also take advantage of these market opportunities.

"And so we think it is both of those things but not a rescue."

—David Viniar, Goldman Sachs CFO

“Look at you. You used to be so cocky. You were going to go out and conquer the world…. What are you, but a…miserable little clerk crawling in here on your hands and knees and begging for help.”

—Lionel Barrymore (“Henry Potter”) to Jimmy Stewart (“George Bailey”), “It’s a Wonderful Life.”

Well the cocky folks whose leveraged “quant” funds have helped bring the current crisis upon the world’s capital markets—Goldman Sachs—held a conference call Monday to describe some steps they’re taking to alleviate the very same crisis which their leveraged “quant” funds helped trigger.

Just don’t use the word “rescue” to describe Goldman’s moves.

No, the wonderful folks at Goldman are not “rescuing” the troubled Global Equity Opportunities fund. They’re simply taking advantage of what Sam Wainwright—the greedy government-contract profiteer and boyhood friend of “It’s a Wonderful Life” hero George Bailey—might have described as “the opportunity of a lifetime.”

At least that's how Goldman Sachs CFO David Viniars described the $3 billion weekend-organized emergency propping-up of the Global Equity Opportunities (“GEO”) fund:

Goldman Sachs is partnering with various investors, including C.V. Starr & Co., Perry Capital and Eli Broad to invest $3 billion in GEO. This investment reflects our collective belief that the value of this fund is suffering from a market dislocation that does not reflect the fundamental value of the fund's positions.

Since we here at Not Making This Up strive to, well, not make things up, we here at Not Making This Up will indeed use the term 'rescue' no matter what the folks at Goldman want to call it.

For that is precisely what it is.

Now, the fund being rescued—the Global Equity Opportunities fund—ought not be confused with Goldman’s other big “quant” funds, including the Global Alpha fund, the North American Equity Opportunities fund or even the Global North American European Alpha Phi Beta What Happens in Sub-Prime Stays in Sub-Prime fund which we just made up but sounds about as good as anything else out there.

No, those other Goldman funds are so highly differentiated from the Not-Being-Rescued Global Equity Opportunities fund that they have generated completely non-correlated positive results that have fully offset the losses at the Not-Being-Rescued Global Equity Opportunities fund.

Actually, I’m making that up.

Those other Goldman funds have also, unfortunately, gotten crushed, which calls into question,

1. What differentiated strategies were they pursuing that yielded such a highly correlated co-efficient of returns?

2. What is a co-efficient of return anyway, and when did the gamma of the beta begin to lose its alpha?

3.Why do these funds all have different names in the first place?

Whether the other funds will need to Not Be Rescued like the fund that is Not Being Rescued remains to be seen, although the Goldman team somewhat bizarrely stated on their conference call that the reason they rescued—er, invested in—the “Global Equity Opportunities” fund as opposed to the “Global Alpha” fund and the “North American Equity Opportunities” fund is because they prefer “global opportunities.”

As if the “Global Alpha” fund is not a “global” fund.

Now, we here at Not Making This Up tend to give Wall Street’s Finest a hard time for their deferential manner on conference calls, by which I mean their incessant use of the phrase “Great quarter guys” as a substitute for “Hello,” not to mention their preference for asking “housekeeping” questions about the tax rate as opposed to business questions that actually matter.

So it is only fair to call out Susan Katzke of Credit Suisse, who showed on the Monday call why asking good questions makes a difference, during an interchange with Goldman CFO David Viniar about the stupendous leverage still residing in the Not-Being-Rescued fund as of Monday morning.

Note how Viniar tried to downplay the leverage in the Not-Being-Rescued fund, and actually understated it by half before Katzke forced him to cough up the truer picture of just how much trouble the “quants” had gotten into, when the gamma of their beta lost its alpha.

This is from the indispensable Street Events:

Susan Katzke, Credit Suisse:

Okay. And just I don't know if you covered this with Roger -- I might have missed it -- but in terms of the leverage in the funds, what are the leverage parameters, and where do you expect them to be going forward? Were they in retrospect a little bit higher than you would have liked them to have been or will be going forward?

David Viniar, Goldman Sachs CFO:

They were higher than we wished they were given how fast the market moved, but they were right in line with what had been expected. And the leverage at GEO as we sit here now is around 3.5 times, which is actually a little bit under where we had told people we would operate but probably around where we will operate going forward.

Susan Katzke, Credit Suisse:

Okay. And the 3.5 times just to clarify is with the $3 billion equity investment?

David Viniar, Goldman Sachs CFO:

With the equity investment.

Susan Katzke, Credit Suisse:

Okay. So closer to 6 times before that.

David Viniar, Goldman Sachs CFO:

That is correct.

Ah, those cocky quants who were going to go out and conquer the world!

Jeff Matthews
I Am Not Making This Up

© 2007 NotMakingThisUp, LLC

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.


buckeye1 said...

Great post as usual Jeff. I've never understood the need to lever up 6x to make slightly above average equity returns. As Warren Buffett said (may not get this one completely right), if you're not that good you shouldn't use leverage and if you are good then you don't need it.

Mebane Faber said...

6:1 ?

A good friend of mine would say, "That's a bowl full of thats what you get".

I mentioned this other stellar quote on my blog World Beta from the Goldman CFO:

"We are seeing things that were 25-standard deviation events, several days in a row"

So, that is an event that happens, what, every 100,000 years? SEVERAL DAYS IN A ROW?

punchcard said...

Great laughs Jeff, thanks. Everyone knows what it really means though. Calling Hank Greenberg an "opportunistic investor" is understating things a little, and it can't be easy to admit that you have him on speed dial (with his toxic reputation).

Would be fun to know all the terms he squeezed out of them though, beyond cutting the fees to mutual fund levels.

smithycroftman said...

In February of this year Mark Carhart, the PM of Global Alpha was quoted as saying Buffett had it all wrong, but he did have one redeeming quality, that he told great stories. I bet Carhart's story will be a doosie! J K Galbraith famously said that financial genius was leverage and a bull market. Maybe the quants should read a little more and count a little less.

Howard said...

awesome. awesome

SiamTwin said...

next target for your quiver of arrows - Blankfein's apology to Russia's VTB for Goldman analyst's sell rating. he should be ashamed of himself...

BelowTheCrowd said...


First: presume that the deviations in portfolio returns are defined by a bell curve, even though history suggests that they don't. You have to do this, because otherwise none of modern statistics can be applied, and you have to look for a new job.

Second: use the bell curve to determine the liklihood of an event happenning.

Third: when the once-in-a-million-years events happen every decade or so, don't blame your misuse of statistics to model something that can't be accurately modeled with them. Claim that your models were fine, but they just couldn't take into account the once-in-a-million-years events that happen every ten years or so.

Fourth: Repeat ten years later.


Doug said...

Just a day before GS announced the non-rescue, the owner of the collapsed Utah coal mine was adamant about the distinction between a "rescue" vs a "recovery" in his word choices. At the coal mine, a rescue assumes survivors, whereas a recovery seeks only bodies.

Yet at the coal mine, where a rescue would require a 25 sigma miracle, only the word "Rescue" can be used. But at GS, where with enough capital, a rescue is possible, the use of the word, rescue is verboten.

jmf said...

Thanks from Germany

Marc Gilbert has also done an excellent piece about

Short-Term Capital Mismanagement LLP.

Very funny stuff.

Make sure you have no coffee in your mouth :-)

DAL said...

Good stuff. just found this blog. I wonder how the quants have handled the volatility this week. Interested to see what the headlines look like in 3 weeks on this front

Randy said...

"Goldman's largest hedge fund, managed by Mark Carhart and Raymond Iwanowsk, has dropped almost 40 percent since July 31, 2006, said the people, who declined to be named because the fund is private. The Standard & Poor's 500 Index of the biggest U.S. stocks has returned 16 percent during the same period."

While he's good at at spinning yarns, Buffett has never trailed the market by 50% in a year. His only one year loss is 6% (by book value) over a 50 year + period.

There is something to be said for the boring work of bland stocking picking, without leverage or exotic financial instruments to juice returns. You might only achieve 20% a year, but at least you'll do it without the excitement of a Carhart level blowup.

Uly said...

So they went from 6x leverage to 3.5x leverage. So the (old) investors in went down at 6x when they were told the fund would only take half of that leverage, and now if the investments recover they will only ride up at 3.5x. Plus they still bear the mgmt fee while the new money gets exempted. I wouldn't be too happy if I were them.