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Loss at Goldman Hedge Fund Racks Duo at Secretive Global Alpha

Date: Wednesday, January 31, 2007
Author: Richard Teitelbaum, Bloomberg.com

(Bloomberg) -- Mark Carhart looks out over the packed New York conference and tells investors that Warren Buffett has it all wrong.

Carhart, 40, co-head of the quantitative strategies group at Goldman Sachs Group Inc., uses his July speech to poke fun at the Berkshire Hathaway Inc. chief executive officer's penchant for investing in market-leading brands like Coca-Cola and Gillette. He cites study after study showing that big-name companies with high price-earning multiples or rapid growth rates make poor bets.

Traditional stock pickers like Buffett, a fabled raconteur, do have one redeeming quality, Carhart jokes: ``They tell great stories.''

Carhart himself has a pretty good story to tell. Though he doesn't like to talk about it, Carhart is one of the world's most successful money managers, a mastermind behind Global Alpha, a $10 billion hedge fund for wealthy clients and employees of Goldman Sachs.

In 2005, Carhart and co-manager Raymond Iwanowski, 40, notched a 51 percent gross return at Global Alpha. Posting that kind of gain requires taking risks -- and last year, Alpha lost 6 percent, its first deficit since 1999.

Carhart, a former assistant professor of finance at the University of Southern California, helps oversee other hedge funds, four mutual funds and scores of separate accounts. In all, he and Iwanowski have $101.5 billion at their command. Carhart and Iwanowski use math-heavy trading tactics that fund consultant Sol Waksman likens to counting cards in a casino. The two lead a corps of computer-loving traders, statisticians and finance and economics Ph.D.s.

Behind the Scenes

Their team makes -- and sometimes loses -- millions of dollars a day. At the heart of their empire is Global Alpha, which generated about $700 million in fees for Goldman Sachs in fiscal 2006. This money machine hums mostly behind the scenes. Asked about the fund, Goldman spokeswoman Andrea Raphael declines to confirm even its name.

Carhart and Iwanowski, friends since their days at the University of Chicago Graduate School of Business, oversee about 10 other Goldman hedge funds, too. Together, they trade everything from Japanese stocks to U.S. soybeans, to Israeli shekels.

Global Alpha is part of the richest hedge fund empire the world has ever seen. Last year, Goldman Sachs eclipsed D.E. Shaw & Co. and Bridgewater Associates Inc. to become the largest hedge fund manager, with $29.5 billion in assets as of Dec. 31, according to Bloomberg and Chicago-based Hedge Fund Research Inc., which tracks the industry. That figure excludes Goldman's proprietary-trading funds and its funds of hedge funds.

Goldman Secrets

Working out of a granite-and-glass office tower a few blocks from Goldman Sachs's Broad Street headquarters in lower Manhattan, Carhart and Iwanowski hunt for market variables called risk factors that often lead to excess investment returns, or premiums, according to people familiar with the fund.

Some, such as a measure called the value premium -- the difference between the return of a group of stocks with high book values relative to their prices and that of a group with low book value-to-price ratios -- have been used by other money managers for years. Goldman Sachs has identified more than 20 new risk factors, which it doesn't disclose, even to its own investors.

Carhart never reveals the secrets. Old friends and people who've invested in the fund say they're not really sure how it works.

John Cochrane, one of Carhart's professors at the University of Chicago, says that based partly on what Carhart has told him -- not much, he admits -- Goldman Sachs has devised five or so proprietary risk factors for equity markets.

Inside Global Alpha

Kelly Welch, a Chicago classmate and former portfolio manager at the $2.1 billion Ewing Marion Kauffman Foundation in Kansas City, says Carhart builds computer models that use Goldman and other variables and historical data to decide what to buy and sell.

``Mark has never discussed the specifics of the new factors with me,'' says Welch, now a finance professor at the University of Kansas.

Interviews with Cochrane, Welch and others who are familiar with Carhart, Iwanowski and their fund provide a glimpse into Global Alpha. So do documents that Goldman Sachs has filed with the Irish Stock Exchange for Goldman Sachs Global Alpha Fund Plc, a Dublin-domiciled fund for non-U.S. investors. This Irish fund tracks its U.S. counterpart.

On any given day, Carhart's team of 50-60 investment professionals uses Global Alpha's factors to deploy 20 trading strategies in markets the world over, according to an investor in the fund and Global Alpha documents. During 2006, the fund's picks ranged from Japanese and Dutch stocks to bets on and against the Polish zloty.

Quant Shop

``It's in everything from commodities to emerging markets,'' says Dan Kapanak, manager of investment strategy at the $26 billion Arizona State Retirement System, which invests in a separate Goldman account.

At the center of the Global Alpha story are Carhart and Iwanowski, devotees of quantitative analysis, or quants, who came to Goldman Sachs from opposite ends of the financial world.

Carhart first turned heads in money circles as a doctoral candidate at the University of Chicago and later as an assistant finance professor at the University of Southern California's Gordon S. Marshall School of Business. Iwanowski, by contrast, has spent his entire career on Wall Street.

What unites them is that they're quants, who put their faith in data, rather than human judgment, when deciding what to buy or sell. To money managers like them, what you think about a company's management or products doesn't matter much.

2006 Losses

Jokes aside, Carhart would do well to heed two Buffett rules. No. 1: Never lose money. No. 2: Don't forget rule No. 1. In 2006, Global Alpha went wrong when just about everything else at Goldman Sachs went right. After a roller-coaster ride that included a 10 percent August plunge, Global Alpha ended the year down 6 percent, according to an investor in the fund.

The loss, the first since 1999, came in a year when Goldman earned $9.54 billion, the most in Wall Street history. The investment bank made headlines by earmarking $16.5 billion for salaries and bonuses, including a record $53.4 million bonus for Chief Executive Officer Lloyd Blankfein. Carhart and Iwanowski declined to comment for this story, as did other Goldman Sachs executives.

It was a rare misstep for Global Alpha. The fund skated through the 2000-02 U.S. bear stock market without a down year and posted an annualized return of 19.75 percent, after fees, from Dec. 4, 2001, to Dec. 31, 2005, according to Global Alpha's 2005 annual report. The average hedge fund returned an annualized 9.1 percent from Dec. 1, 2001, to Dec. 31, 2005, according to Hedge Fund Research. Shares of Buffett's Berkshire Hathaway rose a mere 5.9 percent during the period.

In a Hole

Only now, Carhart and Iwanowski are in a hole. Like most hedge funds, Global Alpha charges an annual management fee of 1.5 percent or 2 percent and takes a 20 percent cut of any profit. Before the fund can take its 20 percent in 2007 -- assuming it makes money -- its quants must first make up the 2006 loss.

The hiccup will cost Goldman Sachs. During a December conference call, Chief Financial Officer David Viniar told analysts to brace for a sharp fall in reported hedge-fund and other incentive fees during the first fiscal quarter of this year.

``It will be significant,'' Viniar said.

Hedge fund managers industrywide face a sober reality: The days of easy money are over. Since 2000, this corner of the financial world has more than doubled in size.

Hedge-Fund Explosion

Worldwide, there are now more than 9,000 hedge funds, which are loosely regulated pools of capital that enable managers to participate substantially in investment returns. So many hedge funds have crowded into the markets that the industry is struggling to generate standout profits.

In Wall Street parlance, the extra risk-adjusted return a fund earns above a benchmark, say the S&P 500, is symbolized by the Greek letter alpha -- as in, Global Alpha. Alpha is getting hard to find. The average hedge fund gained 13 percent in 2006, according to Hedge Fund Research. Investors would have made more money buying a mutual fund that tracks the S&P 500, which returned 15.8 percent.

Waksman, founder of Fairfield, Iowa-based Barclay Group, a hedge fund database and consulting firm, says the odds that a quant fund like Global Alpha will lose money in 2007 are about the same as they were in 2006. No hedge fund manager wants to have to deal with losses. ``When you have a difficult year, the stress of that is just tremendous,'' he says.

For Carhart and Iwanowski, a second down year, especially a double-digit loss, could be trouble.

Pressure Is On

``If you're down significantly for two years in a row, it's likely that an investor will be reconsidering an investment,'' says Theodore Aronson, principal of Aronson + Johnson + Ortiz LP, a Philadelphia-based investment firm with $28.3 billion in assets under management.

Up in 32 Old Slip, the atmosphere is more university tweed than Wall Street pinstripe, people who have been there say. Carhart often rides his Trek bicycle to work from his Upper West Side home seven miles away. He and his team are part of the $676 billion Goldman Sachs Asset Management division, which employed 23 Ph.D.s in portfolio management at the end of 2004, according to its Web site.

Inside the open-plan office, the mostly male quants favor everyday-casual khaki pants and blue-and-white oxford shirts, rather than the suits and ties of Goldman investment bankers. Carhart has a sweet tooth and has new analysts stock a drawer with candy. He likes the strawberry Twizzlers. Iwanowski prefers peppermint Altoids.


One of the most-surprising things about Carhart is that for a guy in an industry known for big money and bigger egos, it's hard to find anyone who'll say a bad word about him. Former colleagues, classmates and teachers remember him as one of the smartest people they've known.

``How can you say, `outstandingly brilliant,' in another way?'' says Mary Crago, his junior high school English teacher in Yakima, Washington, where Carhart grew up.

Mark Monroe Carhart has been at the head of his class since his days in Yakima, a city in a rural part of central Washington known for its apples and hops. He's the second of three children of Whitfield Carhart, a U.S. Army radiologist who tended orchards, and his wife, Mary, a school teacher.

Students at Eisenhower High School viewed Mark -- math team champ and a trumpeter in the pep band -- as a school brain, Crago says. They called him ``Marcus Aurelius Piscarus Carhartus,'' she says.

`The Inventor'

After he helped devise a contraption that enabled its user to toss a raw egg off the school roof without it cracking, they gave him another sobriquet: ``The Inventor.''

After graduation, Carhart headed for Yale University, where he majored in economics and served as managing editor of the Yale Economics & Business Review. He also began dabbling in the markets as a director of the Yale College Student Investment Group.

Members sometimes learned lessons the hard way, says Stephen Lange Ranzini, former group managing director and now CEO and majority-owner of Ann Arbor, Michigan-based University Bancorp Inc.

One story: a group member forgot to close out a pork belly futures contract. Teamsters showed up with two truckloads of meat. The hapless student-speculator ended up selling the pork to the university dining service at a loss, Ranzini says.

The club, which had about $100,000, shifted about 13 percent of its portfolio into cash a week before the 1987 market crash. Carhart, as a director, would have been involved in that decision, says Charles Tillen, a Yale classmate who's now a partner at Bain & Co., a Boston-based consulting firm.

Future Career

While some members were prone to snap judgments, Carhart analyzed companies' cost of equity, industry growth and stock-price volatility, Tillen says. In the Yale Banner of 1988, Carhart lists his future occupation: portfolio management.

After Yale, Carhart set to work on a doctorate in finance at Chicago. He studied under finance professor Eugene Fama, best known for his work on the efficient-market hypothesis, which holds that prices reflect all there is to know about stocks or other securities.

Fama still recalls how hard Carhart worked on his dissertation, entitled ``Survivor Bias and Mutual Fund Performance.'' Carhart found a company in Des Moines, Iowa, that had kept old data on mutual funds, Fama says.

Carhart had the numbers keyed into a computer by hand -- a process that took several years. Using this database, he found that mutual fund figures artificially inflated returns because fund companies tended to shut laggard funds or merge them into other funds, stripping their performance numbers from totals.


``He's one of the most-persistent people I've met,'' Fama says of Carhart. Today, the database lives on at the Center for Research in Security Prices at the University of Chicago.

In the second part of his dissertation, later published as ``On Persistence in Mutual Fund Performance,'' Carhart examined why fund managers who do well one year tend to do well the next. Was it talent -- ``hot hands,'' in fundspeak -- or something else?

Carhart concluded that back-to-back gains mostly reflected the momentum of stocks in a fund, rather than a manager's smarts. It's not exactly the conclusion you'd expect from someone hoping for a career in money management.

Cochrane, who advised Carhart on his dissertation, says that at first he challenged the idea. ``He just quietly explained it to me,'' Cochrane recalls. ``It sticks in my mind because he was right, and I was wrong.''

After collecting his doctorate in 1995, Carhart joined the faculty at USC's Marshall School. Kevin Murphy, vice dean of faculty and academic affairs, says Carhart impressed his colleagues with his teaching -- and with 100 mile-a-day bike rides into the Santa Monica mountains.

Inflating Returns

In his research, Carhart kept hammering away at mutual funds. In a paper entitled ``Leaning for the Tape: Evidence of Gaming Behavior in Equity Mutual Funds,'' which was eventually published in 2002 in the Journal of Finance, he presented evidence that some managers tended to buy more shares of their largest holdings at the end of financial quarters.

Carhart said these purchases drove up the stocks' prices, thereby inflating funds' quarterly results. Higher returns, of course, often mean higher bonuses for managers.

In public, many mutual fund managers denied the practice occurred, says Ron Kaniel, co-author of the paper and now an associate professor of finance at the Duke University Fuqua School of Business. ``Then, when you went off the record, they would admit it happened,'' he says.

Given his published research and classroom work, Carhart was headed for tenure. ``Mark was on a perfect trajectory,'' Murphy says. Then Goldman Sachs called.

Iwanowski's Arc

Ray Iwanowski never had the temperament for a life inside the ivory tower, people who know him say. From the start, he put his head for numbers to work making money.

Raised in Dallas, Pennsylvania (2000 population: 2,557), Iwanowski graduated from the University of Pennsylvania in 1988 with twin bachelor's degrees in math and finance. He promptly went to work at First Boston, now part of Credit Suisse Group, in the fixed- income portfolio strategies group in New York. In 1990 he left, heading to graduate school at Chicago, where he met Carhart.

For Iwanowski, it was a stopover on the way back to the Street. He collected his MBA, began work on his doctorate -- and left before finishing his dissertation. In 1993, he joined Salomon Inc., now part of Citigroup Inc.

Thomas Klaffky, who helped hire then 27-year-old Iwanowski, set him to work writing a series of booklets for clients explaining how complex financial instruments worked. The idea was to educate customers and, in the process, cement client relationships, says Klaffky, who's now managing director at Citigroup Global Markets.

At Salomon

``The difference between an intelligent person and a brilliant person is the brilliant person can explain complicated issues to anyone,'' Klaffky says. He recalls Iwanowski as the latter.

Salomon named Iwanowski head of its fixed-income derivatives client research group at its 7 World Trade Center offices. He did research and also wrote articles for publications such as the Journal of Fixed Income. One of his pieces published there, co- authored with then colleague Antti Ilmanen, was entitled ``Dynamics of the Shape of the Yield Curve.'' The paper examines how market expectations and other factors affect bond rates.

Janet Showers, who ran fixed-income strategy and worked in the office next to Iwanowski's, says she suspected his destiny lay elsewhere. ``I wasn't surprised that he didn't end up as a career person writing research,'' Showers, now retired, says. ``He wanted to manage money.''

During the mid-90s, as Carhart finished his dissertation and Iwanowski penned research, Goldman Sachs was building out its asset management arm. The investment bank had been reluctant to manage other people's money in part because the 1929 crash virtually wiped out Goldman Sachs Trading Corp., an investment trust.

Building Up

The disaster of '29 cost partners and clients millions of dollars, according to ``Goldman Sachs: The Culture of Success'' (Touchstone Books, 1999) by Lisa Endlich.

In 1995, then CEO Jon Corzine and then President Henry Paulson tapped John McNulty, a former broker who had managed Goldman's Miami office, to build a competitive money management division.

``They said, `We don't need you to contribute anything to the bottom line, but build us something we can be proud of,''' recalls John Casey, a Darien, Connecticut-based consultant whom Goldman hired to help McNulty evaluate potential acquisitions. McNulty died in 2005.

Goldman Sachs snapped up U.K.-based CIN Management Ltd. and Tampa, Florida-based Liberty Investment Management. In 1997, it bought Princeton, New Jersey-based Commodities Corp., a den of Ph.D.s co-founded by Paul Samuelson, a Nobel Prize winner and author of the best-selling college textbook on economics.

Global Alpha Is Born

Inside Goldman Sachs, Clifford Asness, another student of Fama's with a Ph.D. from Chicago, was building quantitative models.

McNulty liked what he saw. ``Isn't this quantitative stuff better than anything else we're doing?'' Casey recalls McNulty asking.

The result was Global Alpha, which Goldman Sachs seeded with $10 million. To help Asness, Goldman recruited fellow Chicago alums Robert Krail and John Liew. In January 1997, Asness hired Iwanowski. That September, he hired Carhart.

Some three months later, Asness quit and took nine colleagues with him to found his own hedge fund firm, AQR Capital Management LLC, now based in Greenwich, Connecticut. He didn't take Carhart or Iwanowski.

``They left Mark high and dry,'' Murphy says. Welch says the departures were tough on Carhart.

``Having his friends leave on him like that was very hard for Mark,'' Welch says. Even so, Carhart realized it was an opportunity, he says. AQR officials didn't return telephone calls.

Taking Over

And so, only months after arriving at Goldman Sachs, Carhart and Iwanowski found themselves at the helm of Global Alpha.

Today, Carhart runs his quant shop like a graduate seminar on steroids. Welch says Goldman Sachs is always looking for current or former academics to add to its brainpower. Once a week or so, the group holds seminars with professors or industry figures such as Vanguard Group founder John Bogle, who visited on May 10, 2000.

Global Alpha doesn't merely bet on the direction of stock or bond prices. It bets on differences between those prices.

Global Alpha employs seven strategies in the bond markets alone, according to Goldman Sachs Global Alpha Fund Plc's June 30 semiannual report. The simplest of them is to buy government bonds of one country while shorting those of another.

Goldman's Gambles

In the U.S. stock market, Global Alpha might buy oil and insurance stocks and simultaneously bet against semiconductor shares. The fund also allocates part of its $10 billion to something called ``global event anomalies,'' according to a November 2001 prospectus. With this strategy, the fund attempts to make money from corporate stock buybacks and divestitures and from changes in how market indexes like the S&P 500 are calculated.

Carhart and Iwanowski also employ a commodities strategy and an asset-allocation strategy that bets on various mixes of investments: stocks, bonds, currencies and beyond.

As its name suggests, Global Alpha is, well, global. In addition to sizing up investments in one geographic market, its quants simultaneously measure how those investments stack up against others around the world.

``In the Netherlands, they are asking whether stocks are underpriced relative to bonds or cash,'' Welch says. ``But they are also asking whether they are overpriced relative to Japanese stocks.''

Global Alpha quants have designed their fund so that if things go wrong, the probability is low that the 20 strategies will lose a lot money at the same time. That, anyway, is the idea.

Returns Sour

In the 2005 report filed with the Irish exchange, Global Alpha reported a gross return of 51 percent for the year. The report says only two strategies -- global anomalies and the country bond selection -- suffered losses of more than 1 percent.

During the first quarter of 2006, Global Alpha rose a net 9.5 percent, according to the semiannual report filed with the exchange.

The next quarter, a bunch of the fund's strategies soured. Global Alpha lost 3.5 percent during the period. Its ``developed equity country selection'' fell 2.5 percent, hurt by bad bets on Japanese and Dutch stocks.

Its developed country currencies strategy sank 1.9 percent, whacked by a wrong-way wager on the dollar and another against the pound. Emerging market currencies strategy sank 1.7 percent, nipped by short positions in the shekel and zloty.

Losses Mount

Piecing together the second half of 2006 is harder. A Global Alpha investor who asked not to be identified says the fund's roughly 10 percent slide last August mostly reflected bad bond market investments. Global Alpha also bet that stocks in Japan would rise while those in the rest of Asia would fall -- wrong; that U.S. stocks would stumble -- wrong; and that the dollar would rise -- wrong again. Global Alpha finished November down 11.6 percent in 2006.

The Arizona State Retirement System's Kapanak says hedge funds such as Global Alpha, which follow various strategies and simultaneously bet that this price will rise while that price falls, are designed to make money when world markets move in different directions.

When markets and economies move more or less in lock step, these so-called multistrategy long/short funds struggle, he says.

That's exactly what's happened lately, Kapanak says. ``You're seeing synchronous growth across the globe,'' he says. The U.S., European and Japanese economies are all growing, which means financial markets have been less volatile than they have been in the past, he says.

For Global Alpha, the big question is, Is all this an aberration, a brief setback on the way to greater heights? Or is it the start of something worse?

What Went Wrong?

One answer may be Global Alpha's 5.5 percent rally in December, which accelerated in early January, according to one investor. The fund has benefited from gains in the dollar, strength in Japanese and European stocks versus those in the U.S. and short positions in global government bonds.

Still, Global Alpha may have a hard time repeating its past glories now that it's grown so big, says David Hendler, a senior analyst at New York-based CreditSights Inc. After Goldman Sachs said it would close the fund to new money at the end of 2005, about $2 billion flowed into Global Alpha. Even though the fund invests in so many markets, size could work against Global Alpha, as it has in the past against once-celebrated mutual funds such as Fidelity Magellan.

``When you're the biggest in a particular style, it's tough to shift your portfolio without everybody knowing it,'' Hendler says. ``There is the question of whether you can continue to perform at the same level.''

In this otherwise heady era for Goldman Sachs -- the richest since its founding in 1869 -- it's worth remembering what the late John L. Weinberg used to say. When times were good, Weinberg, a senior partner from 1976 to '90, would remind colleagues that good times don't last forever. ``Trees don't grow to the sky,'' he'd say. Neither do hedge fund returns.

Editor: Gillen (sjp).

To contact the reporter on this story: Richard Teitelbaum in New York at rteitelbaum1@bloomberg.net .