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Market turmoil leaves hedge funds poised between threat and opportunity

Date: Friday, August 17, 2007
Author: Hedgeweek.com

Goldman Sachs Asset Management, which has admitted to losses in the hedge funds it manages totalling up to USD3bn amid continuing fall-out from the US sub-prime mortgage sector meltdown, sums up the mixture of threat and opportunity for the hedge fund sector presented by the continuing market turmoil.

On Monday Goldman said that together with various investors including CV Starr, which is controlled by former AIG chief executive Maurice 'Hank' Greenberg, Perry Capital and billionaire Eli Broad, it would invest USD3bn in Global Equity Opportunities, an equity long/short quantitative strategy fund that had a net asset value of some USD3.6bn before the equity investment after losing as much as USD1.4bn in the first half of this month.

Goldman acknowledges that the performance of the fund has 'suffered significantly' as a result of the market dislocation, as a result of which it has reduced risk and leverage, but argues that the current environment represents an attractive investment opportunity. 'The investment will also provide the fund with more flexibility to take advantage of the opportunities we believe exist in current market conditions,' the firm says.

'Many funds employing quantitative strategies are currently under pressure as recent conditions have resulted in significant market dislocation. Across most sectors, there has been an increase in overlapping trades, a surge in volatility and an increase in correlations. These factors have combined to challenge many of the trading algorithms used in quantitative strategies. We believe the current values that the market is assigning to the assets underlying various funds represent a discount that is not supported by the fundamentals.'

What Goldman describes as taking advantage of an opportunity, more sceptical observers see as a bail-out. The firm is understood to have waived its 2 per cent annual management fee and halved its performance fee for new investors and additional investment by existing investors, in exchange for a commitment to keeping their money in the fund for at least six months. Existing investors can withdraw their money monthly on 15 days' notice.

Goldman admits that its flagship Global Alpha multi-strategy hedge fund and the North American Equity Opportunities Fund, an equity long/short quantitative strategy, have also been affected by the knock-on effects on the sub-prime problems on credit markets and in turn on equity quantitative strategies. 'We have reduced risk and leverage in these funds as well,' the firm says. 'At their current levels of equity capital, we believe the funds are positioned to actively pursue market opportunities.'

Not all hedge fund managers have Goldman's deep pockets and ability to wait out the market storm in search of windfall profits from undervalued assets, especially those whose funds have direct exposure to US asset-backed securities. The level of market anxiety was cranked up a notch at the end of last week when BNP Paribas Investment Partners announced that it was no longer able to calculate net asset values or handle subscriptions or redemptions of three of its funds, Parvest Dynamic ABS, BNP Paribas ABS Euribor and BNP Paribas ABS Eonia.

'The complete evaporation of liquidity in certain market segments of the US securitisation market has made it impossible to value certain assets fairly regardless of their quality or credit rating,' BNP Paribas said. 'The situation is such that it is no longer possible to value fairly the underlying US ABS assets in the three funds. In order to protect the interests and ensure the equal treatment of our investors, during these exceptional times, BNP Paribas Investment Partners has decided to temporarily suspend the calculation of the net asset value as well as subscriptions/redemptions.'

Other managers, including Germany's Union Investment and Frankfurt Trust and joint venture WestLB Mellon, have halted redemptions from funds investing in asset-backed securities, whether or not they include sub-prime mortgage assets, because investor flight has caused liquidity to dry up.

Last month Sowood Capital Management, a firm founded by former Harvard University endowment manager Jeff Larson, was forced to sell the assets of its two funds to Citadel Investment Group after they lost more than half their value in the course of July. Sowood approached Citadel because the firm feared it might not be able to meet margin calls and that it could be forced by creditors to unload its assets at fire-sale prices.

Other leading managers of quant strategies that are known to have made significant losses include JP Morgan's Highbridge Capital Management, whose market neutral was down 6 per cent, Renaissance Technologies, whose Institutional Equities Fund is reported to have lost 8.7 per cent in the first week of August, Tykhe Capital and AQR Capital Management.

The losses suffered by quant managers as their computer-driven models failed to cope with volatile equity prices and widening credit spreads recall the market turmoil prompted by Russia's default in August 1998, which led to the celebrated collapse of Long Term Capital Management. Then the correlation of falling prices across asset classes was described as a 'once in a century' combination of circumstances, an expression that was heard again from agitated traders this week.