Monday, September 19, 2011

Regarding Goldman's Global Alpha Fund

I read the article in Friday's Wall Street Journal concerning the closing of Goldman Sachs' Global Alpha fund with great interest.

Coming as it did on the heels of the UBS so-called rogue trader loss, and this related, recent post, it brought to mind, once more, Michael Lewis' books about publicly-owned investment banks.

The story is rather eye-opening. Begun with Cliff Asness at the helm in 1997, he bolted to form his now-famous AQR hedge fund the next year. No mention of where Global Alpha existed, organizationally, in relation to GSAM, the firm's formal asset management arm. But the Journal piece states that Global Alpha ran $12B in 2007, lost 23% of that "in August 2007 and was down 40% for all of 2007."

According to the Journal article, the fund lost 12% so far this year, and had fallen to just $1B in size. So Goldman has shuttered it.

Global Alpha's last manager, Katinka Domotorffy, is leaving the firm. No doubt with tens of millions of dollars of her own, soon to set up shop managing her own funds and those of a few select friends or colleagues. Perhaps as a consultant, in order to avoid the intrusive new hedge fund rules which have driven Carl Icahn from the business.

I can't help but muse about Goldman's experience with Global Alpha and, perhaps, other funds. I'm sure they charge premium fees. I doubt they allowed much of a hold-back period on incentive fees, or refunded any fees as they closed Global Alpha.

Along with proprietary trading, which former CEO John Whitehead thought a bad idea, so, too, has asset management apparently proven to be an expensive new business- for Goldman's clients.

Even at just an average size of $5B, Global Alpha was probably earning at least $100MM annually in management fees, and who knows how much more by executing the fund's trades on Goldman's own desks? Then there are the incentive fees in the good years, which for the year in which it earned 30+%, translates into another 6% of assets, or $300MM in additional revenues. The fund doesn't take a share of losses, so this asymmetric payoff, along with redemption lockups, can quickly result in sizable income for Goldman.

Add in the fund manager's probable large cuts for not leaving to join folks like Asness in the true private hedge fund business, and you have Global Alpha becoming a gigantic funnel for client assets being transferred to Goldman fund managers, bit by bit.

Heads, both parties win, tails, the client loses and, eventually, departs.

From Goldman's perspective, it's even richer than brokerage or proprietary trading, because there's a nice fixed fee, regardless of the client's losses. Yes, over time the fund can tank, as Global Alpha eventually did. But the problem is firewalled to just that fund.

If Goldman was able to manage an average of $5B for almost 15 years in Global Alpha, I'm sure it was a very lucrative venture for the firm and the fund's managers, regardless of how much the fund's investors ultimately lost before redeeming.

This is a theme on which Michael Lewis touched in The Big Short. Something most people can't quite comprehend.

When fund assets reach such large sizes that fixed fees alone provide adequate revenues, in a very few years, the firm and the fund's managers can become sufficiently wealthy from their cuts that they simply don't have to care so much as they may have initially what happens to their investors' money.

Today's Journal profiles celebrated fund manager John Paulson in the midst of a tough year. His funds have apparently struggled so far in 2011, posting losses. Paulson's funds are reported to have attracted something like $10B in new money in recent years, which doubled the amount of outside funds under management.

But the article also mentions that, as a result of his very public success betting against mortgage-backed bonds during 2005-08, Paulson personally took home $5B in pre-tax earnings in 2010.

Read that again. $5B last year.

Even if Paulson invested and lost half of that in his own funds, he still kept at least a billion after tax.

How can you reasonably expect him to manage investor funds the same way now as he did before 2005? Sure, he's no doubt competitive and values his reputation. But, like Julian Robertson, who got sloppy with risk management at the end of his Tiger Fund's run, Paulson no longer is staking his ability to make a living on how his funds perform.

At 2 & 20, with even just $20B in outside money, Paulson's complex is earning $400MM in annual fixed fees, regardless of performance. If you allow for extravagant expenses, the group is probably bringing at least $300MM to its compensation pool.

How many businesses do you know of which provide such life-altering compensation in just one or two years, regardless of how customers fare?

I'm not saying it's unfair, or requires regulation. I'm saying investors should beware of jumping into mega-sized, successful hedge funds, expecting a continuation of past performance.

One needn't invest with Bernie Madoff, nor any Ponzie scheme, to experience disappointing results from a hedge fund. Size (of funds) does matter, and investors who ignore that do so at their peril.

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