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Wall St. humbled by hedge funds

Some of the investment vehicles may be victims of their own popularity.

August 14, 2007|Walter Hamilton and Tom Petruno | Times Staff Writers

new york -- Hedge funds became the investment vehicle of choice for many pension plans and wealthy individuals in recent years, developing a cachet as can't-miss outfits run by the investment world's smartest minds.

But in the last few weeks, several prominent funds have been clobbered by turmoil in financial markets, denting the hedge-fund industry's carefully honed image.

The latest casualty was revealed Monday as Goldman Sachs Group Inc., which has produced three U.S. Treasury secretaries and is considered Wall Street's most elite firm, said it arranged to pump $3 billion into one of its funds that lost about one-third of its value last week alone. Some of the cash is coming from Los Angeles billionaire Eli Broad.

In part, the hedge fund industry may have grown too fast for its own good, with too many funds pursuing some of the same strategies, making it harder for any of them to earn the spectacular returns the industry first became known for.

And when one large fund runs into trouble, entire markets can be roiled, creating problems for everyday investors.

"There is an impeachment of credibility" of the hedge fund industry, says Charles Gradante, a principal at Hennessee Group, which advises fund investors.

The number of hedge funds worldwide has rocketed to nearly 10,000 from 5,400 five years ago. Their assets have surged to $1.7 trillion from $625 billion in the same period.

AQR Capital Management, one of the industry's largest players, told clients in a letter Friday that returns on its funds that used a particular computer-driven strategy to trade stocks had been "shockingly bad" recently.

Why? "The very success of the strategy over time has drawn in too many investors," AQR said.

Another problem hammering some hedge funds: their heavy use of borrowed money to magnify profits.

The use of debt helped trigger the demise last month of two multibillion-dollar hedge funds run by Bear Stearns Cos., another premier investment bank. The funds collapsed as their huge holdings of high-risk mortgage bonds crumbled.

Hedge funds -- largely unregulated private investment pools for the well-heeled -- are the ultimate opportunists, able to pursue virtually any investing or trading strategy in search of hefty returns for their clients.

But that same opportunism has led some of the portfolios to devastating losses this year.

In Goldman's case, the $3.6-billion fund getting the capital infusion invested in stocks worldwide. The fund, called Global Equity Opportunities, didn't simply buy and hold shares, however. Using sophisticated computer programs, it bought some stocks while "shorting" others, a bet that they would drop in price.

Last week, many of the fund's bets went terribly awry and its value sank at least 30%, David Viniar, the brokerage's chief financial officer, said during a conference call with investors.

Goldman blamed, in part, a surge in the stock market's volatility.

But another problem was the fund's use of borrowed money -- one of the main drawing cards of hedge funds. Goldman said the fund had borrowed six times the amount it had raised from its investors.

When securities prices are moving the way a hedge fund manager expects, the use of borrowed money can produce spectacular returns. But when markets go into a tailspin, investors who have loaded up with debt see their losses multiply and can be forced to quickly liquidate assets to pay down their loans.

Goldman said the Global Equity fund was in the process of paring its debts.

To be sure, in an industry with nearly 10,000 separate portfolios worldwide, not every hedge fund has been slammed. Many still are quite profitable year to date, depending on which of the myriad strategies they have followed with stocks, bonds or other securities. In part that's because many of the funds actually do "hedge" -- meaning, they try to reduce the odds of incurring serious loss.

The average hedge fund was up 0.5% in July, according to Hedge Fund Research Inc. By contrast, the Standard & Poor's 500 index of major U.S. stocks slumped 3.2% for the month.

The Goldman fund's woes point up a challenge faced specifically by hedge managers known as "quants," shorthand for quantitative, an increasingly popular investing style.

Hedge funds that follow quantitative strategies use computers to take the emotion out of investing. One popular strategy is called long/short: Basically, the computer is programmed to buy stocks of companies with strong business outlooks and sell those with weak outlooks.

But last week, stock markets worldwide hit a pocket of extraordinary volatility. Some investors were dumping shares of otherwise healthy companies, while other investors were buying beaten-down shares of weak companies.

That was the opposite of what Goldman's computer programs had expected -- catching its fund flat-footed.

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