Goldman Sachs Hedge Fund Strategies (GSHFS) grew out of Commodities Corporation. Commodities Corp. was a company where some of today's best traders began their careers – traders like Ed Seykota, Michael Marcus, Paul Tudor Jones, Bruce Kovner and Louis Bacon all began at CC. Commodities Corp. at one time was considered a model of bustling entrepreneurship.

It was also perceived to be a place of work which was somewhat Ivy League and preppy in atmosphere and style, reflecting that it was founded by a Nobel Laureate in Economics (Paul Samuelson) and someone with a Ph.D. from MIT (Helmut Weymar). How this sort of organisation can operate and flourish inside a quoted investment bank was the key question that was taken by The Hedge Fund Journal to the London offices of GSHFS located by St. Paul's Cathedral.

When Nadja Pinnavaia, now Head of Hedge Fund Strategies for Europe and Asia (ex-Japan), part of GSHFS, joined Goldman Sachs in 1995 the firm had more idea of what she was to do than she did herself. "At the time I finished my undergraduate course, I knew I wanted to go into finance," she says, "but then I undertook my Ph.D. so it didn't happen until later, I met with numerous banks on the milk-round, including Goldman Sachs."

Ms. Pinnavaia, given a "week off" between finishing her Ph.D. and commencing work, started out in equity derivatives in the London office. She continues, "There was a tremendous amount going on in derivatives at that time. The mid to late 1990s saw an evolution in derivative products; new structures being created and asset allocation being implemented more efficiently through use of derivatives. We had a diverse and broad set of clients ranging from the large index-fund managers to global macro hedge funds and different types of institutional investors, including banks, pension plans and insurance companies throughout Europe and the UK."

Spending time in hedging and structuring equity derivatives is also a very good background for a professional in the fund of hedge funds business. There is obviously exposure to equity markets at all levels from single stock, to the sector level and at the index/market level. But equity derivatives also require an understanding of fixed income for financing, the forward curve, and swaps; and there is often a foreign exchange element too. A well-rounded view of volatility (traded and realised or historic) also emerges from time spent in equity derivatives – this is particularly pertinent for an understanding of convertible bond arbitrage, and obviously the newer strategy of volatility trading. In addition the construction of funds of hedge funds requires a facility with the higher moments of returns/distributions. Correlation, skewness and kurtosis are now concerns of funds of funds managers, but they have always been part of the day-to-day language in derivatives.

After equity derivatives at Goldman Sachs Ms. Pinnavaia spent a couple of years as an executive in the Ultra High Net Worth Clientdepartment at the firm. This too has some relevance to working in hedge fund strategies. As a group the clients that enjoy what has been termed "single stock wealth" (this was the time of the tech bubble after all) have been backers of hedge funds for some time, and are the original providers of capital to the industry. Further, both UHNW clients and institutional investors that use equity derivatives have a preference for developing a relationship with their service providers, whether in asset advisement or structuring. This has become a key consideration after Ms. Pinnavaia moved in 2001 into what was to become the Hedge Fund Strategies group.

A philosophy of the business

"A philosophy of our business is to spend a significant amount of time with our clients," discloses Ms. Pinnavaia. "It is fair to say that I spend most of my time talking to our clients. Part of it is in providing on-going education and part in research with our clients."

The concept seems to be that to add value to the client you must understand their business problem in some depth, only then can the right sorts of solutions be proposed. This is particularly true as demand has shifted.

Comment has been made in these pages recently that institutional investors had imposed their own risk tolerances on providers of multi-manager hedge fund product. One of the effects has been that a low or lower-risk mindset had become predominant amongst funds of hedge funds. That is no longer the case, and the industry has evolved. The leading and largest providers are now offering funds with a range of risk/return characteristics. It is not that there is no demand for the broad, diversified, multi-strategy fund of hedge funds that make up the vast majority of assets in the fund of funds industry. Rather the marginal demand is from existing clients for the next level of product.

Fig.1 Allocations to Broad Strategy Groups at Hedge Fund Strategies

"We see a couple of major trends within the industry," explains Ms. Pinnavaia. "Institutions, and the sophisticated HNWs we serve, are both looking for increased customisation in their hedge fund exposures. The second big trend is a new demand for niche and opportunistic investments." GSHFS has clearly been very successful at running both broadly diversified funds of hedge funds as well as niche strategies for clients.

"In terms of managing the portfolio of hedge funds, we see the key to success as the ability to move capital to unique opportunity sets," states Ms. Pinnavaia. "To be clear, we don't try to time markets, but try and work with the cycles of the strategies." For example GSHFS had a positive view of the opportunities for managers in the distressed debt area from 2002 on. To some extent this is reflected in Fig.1. In this context Event-Driven includes High Yield/Distressed, Special Situations, and Risk Arbitrage.

"Back in 2002 we saw companies beginning to clean up their balance sheets, indicating a positive environment for distressed (managers), shortly followed by special situations, such as restructurings. More recently, corporates, now possessors of healthy balance sheets, are helping to fuel other opportunities such as M&A transactions and buybacks. As such there have been many opportunities in the Event Driven arena. Different geographies also give rise to diverse opportunities, with opportunities in Europe different to those in Asia or the US. Looking forward, the economic cycle will continue to mature and those specific opportunity sets will shift again. The environment ahead may be more challenging for holders of long-only equity. We see an interesting balance of risk and reward in hybrid debt and equity strategies, such as mezzanine capital," states Ms. Pinnavaia. This rotation through the sub-strategies of event-driven illustrates another tenet of GSHFS. "We see it as essential to keep a fresh view on the market opportunity," she says, "and the more broadly informed you are as an investor the better. We don't just take the views of managers as our only input on markets or instruments."

In looking at the sizing of allocations to managers within funds of funds, GSHFS considers the risk and return characteristics of each manager, including the average expected volatility of returns, drawdown patterns and liquidity and leverage characteristics as well as their asset capacity limits and constraints. In addition, GSHFS considers how each manager's returns are expected to correlate to the other managers in a given fund's portfolio. Both qualitative and quantitative criteria are factored into the manager selection process at GSHFS. These criteria include portfolio management experience, strategy, style, historical performance, including risk profile and drawdown patterns, risk management philosophy and the ability to absorb an increase in assets under management without a diminution in returns. GSHFS also examines the organisational infrastructure, including the quality of the investment professionals and staff, the types and application of internal controls, and any potential for conflicts of interest.

The factor risk analysis undertaken is based on several factors which are quite typical for FoF managers to use. These factors include Equity Market Risk (the MSCI World Index), Yield Curve Flattening, Credit, Volatility (of markets, using VIX as proxy), a Foreign Exchange factor, Commodity exposure, and exposure to High Yield. There is no attempt to micro-manage the residual or cumulative factor risk contributed across all the managers. Even if most managers stay within their style boxes (no style drift) there are components of the FoF which may not be readily viewed or readily assessed in this way.

For GSHFS, with a history of early allocations to managers now considered titans of the industry, the legacy managers have tended to evolve into large multi-strategy managers. Such exposures can still have a lot of merit in terms of risk control and absolute return, though often the underlying positions may be opaque even to very large investors. "For the legacy managers we must understand how they themselves allocate to strategies," explains Ms. Pinnavaia", but their flexibility and potential to act quickly is very useful."

She goes further: "Individual managers are our most flexible tool within the strategies. So the sub-style used by each manager can be very important in mitigating or enhancing risk assumption at the fund of funds level. Say within credit hedge funds, a manager can be security selection focussed, resulting in a more credit neutral approach or they may be focussed on security selection with a long credit bias. We may choose a manager that has a long equity market bias, or one that has a more neutral or balanced market exposure, depending upon the style and talent of the manager and the underlying opportunity set. In the end what we are looking to create are thoughtful portfolios that seek to address our clients' investment objectives."

Niche and opportunistic investments

The emerging demand for niche and opportunistic investments that GSHFS observe is addressed with an extension to the traditional building blocks of fund of funds portfolio. Fig.2 shows this.

"We like looking for markets undergoing change" explains Ms. Pinnavaia. "So we have been investors of natural resource strategies for a while. As an example, we recently identified and funded a manager investing in the alternative energy supply space. There are some 250 energy managers clustered around Texas, and we feel we have the resources to commit to identifying unique talent in the arena. To ensure success, we need the intellectual capital to understand the changes that are taking place in markets, and the appropriate expertise to identify the managers that can execute well in that strategy. Where things are hard to do in terms of a market environment or trading strategy, we view that as a great hunting ground to find interesting and unique managers".

At the moment GSHFS has a number of areas under the microscope. The firm (Goldman Sachs Asset Management, of which GSHFS is part) has made a particular effort to get to grips with the investment potential of India. The way they have gone about it says a lot about their way of operating. A recent trip was carried out by the hedge fund analysts and other specialists within the firm. The small group visited hedge fund managers, private equity managers and long-only managers in India. They also spent time with the staff of the Mumbai office of Goldman Sachs. The information and views gathered were disseminated across the team of GSHFS via the global weekly research call held each Wednesday. The results of trips to Brazil and Russia were also shared in this way recently.

"In terms of strategy we won't necessarily be looking only for a straight forward long/short strategy within India," discloses Pinnavaia. "We would also consider a local emerging markets debt manager, or someone in special sits. We would like to take an exposure with a manager that looks at special sits or is engaged in more structured types of transactions in India right now."

"Another interesting area for us right now are the hybrid strategies – where public meets private", she continues. "For fixed income managers we prefer managers that go beyond arbitrage, or playing yield curve shifts. Pure arbitrage in the true sense is hard to come by, so naturally these strategies today deploy more directional risks, whether they be duration, credit or volatility as an example."

GSHFS is also prepared to invest with long-biased managers. "Within the long/short bucket we currently have many diverse exposures, but tend to have a preference for a deep-value, fundamental approach. With the recent sell-off some of our managers are looking closely at valuations within the large caps, but as an example, we also see a role in the European arena for someone with short-term trading ability," imparts Ms. Pinnavaia.

There are a number of areas where GSHFS tends not to go. "We do not currently invest with solely dedicated currency managers, rather most of the exposure we have to FX is through global macro managers," Pinnavaia adds. Hedge Fund Strategies is currently invested with only one volatility trading fund, and generally avoids short option strategies. GSHFS doesn't allocate to hedge fund strategies run by managers within Goldman Sachs Asset Management unless the client specifically requests it.

Illiquidity and emerging managers

A recent industry development has been an increase in funds with long lock-up provisions on investors' capital. Ms. Pinnavaia neatly captures the phenomenon. "We have seen managers extending their illiquidity. Investors must discern between those funds that can justify such extensions and those that can't. A key question we ask ourselves in these circumstances is "Are we being rewarded for this illiquidity, or are all the benefits all to one side? (with the manager)."

The growth of the industry has presented some challenges to funds of funds. The sheer number of new funds is one of them. The super start-ups take a lot of the capital these days, but still FoF companies have to find a way of identifying and working with emerging hedge fund managers. GSHFS used to operate a dedicated fund investing in new managers, Ms. Pinnavaia says.

"Now we establish vehicles which are essentially separate accounts for managers. If we like a new, emerging manager we may fund them in this way." GSHFS then has the ability to minutely examine what the manager does and how they do it with the vehicle over whatever time-frame and frequency of analysis is relevant for the style. "For an emerging manager we have to make a decision after a year – to graduate them to a core position, or not." If GSHFS likes the way it has gone it can add further capital, and if not the vehicle will be closed, because GSHFS will know after that length of time whether they have a long term relationship in prospect. Funds of funds vary in how they react to a fund in which they are invested making losses. GSHFS characterise themselves as patient investors. "At GSHFS we deploy a stop-loss mechanism at the manager level which helps control risk for the overall portfolio. We estimate the maximum drawdown for the individual manager. If it is exceeded then our discipline is to typically redeem. If the managers are sticking to a style and we can anticipate a recovery of the losses then we may look at the situation differently. We are also reflective on past performance. We once funded a manager whilst they were in a significant drawdown.

"When we first commenced our diligence they were experiencing a 20% drawdown. This did not impair our judgement. We gave them capital, they subsequently recovered and continued to generate exceptional returns and we have a great relationship with them," says Ms. Pinnavaia.

Stability of capital at the level of the individual fund can be very important to a fund of funds according to Ms. Pinnavaia. "It is good to be with a manager with a stable capital base as they can take advantage of opportunities when markets are in turmoil."

A listed closed-ended fund of funds

As the end-buyers of hedge funds change, so the means of distribution has to change. The Swiss and London Stock Exchanges have had listed funds of funds available for some years. In July this year Goldman Sachs Asset Management launched the Goldman Sachs Dynamic Opportunities Limited ("GSDO"), a closed-ended, fund of hedge funds which trades on the London Stock Exchange. This is the first closed-ended, exchange-listed investment company launched by GSAM. The multi-currency offering raised US$507 million in aggregate, making it thelargest initial public offering to date of a fund of hedge funds listed on the London Stock Exchange. GSDO invests in a concentrated portfolio of high conviction, established managers employing a broad range of alternative investment strategies, which include both core strategies (i.e., relative value, event driven, tactical trading and equity long/short strategies), as well as other niche strategies.

It would be natural to think that such listings are part of the democratisation of hedge funds, that they are being made available to a wider range of investors. Indeed individual investors can buy the fund on the secondary market as if it were an equity security. The primary capital was raised from a broad range of investors including insurance companies, pension funds, discretionary asset managers and private wealth managers. Liquidity of hedge funds is getting worse as redemption fees have become more common, lock-ups are not unusual and notice periods are extended. Listed hedge fund vehicles offer liquidity that would not be available otherwise. "We've found that it is smaller institutional investors that are particularly keen to have a readily realisable exposure to hedge funds," notes Ms. Pinnavaia. "For certain sorts of investors there are issues of admissibility of the assets, and the Goldman Sachs Dynamic Opportunities Limited is one solution for them."

The differentiating factor – sharing of rich intellectual capital

GSHFS has been a commercial success and is now amongst the largest fund of funds in the world. "We haven't run into problems because of our size," asserts Ms. Pinnavaia. "We still invest with only 143 funds, and we can match the increased appetite for risk that our clients are now demanding through customisation, and our efforts to identify and work with niche and opportunistic strategies. We want to find people doing interesting things in markets, that is our task."
 

GSHFS shares some of the style of operating of the parent company. The personnel policies are the same. Yes, the famously elongated assessment of candidates goes on at GSHFS as elsewhere in Goldman Sachs. But GSHFS staff members also do the other things that single out Goldman Sachs as a place to work – the willingness of senior employees to give time to juniors, and the time given to training. The development of staff is clearly a corporate goal."The quality of the people I have to work with is the best thing about the job," declares the enthusiastic Ms.Pinnavaia.

"Our differentiating factor as a fund of hedge funds is the Goldman network," she states. "We tap into the embedded knowledge of the whole company in what we do. We have access to and use the models that analyse risk across and for the whole company. If there is expertise we can use elsewhere in the group, we can usually get access to it."

The recent project on India is a case in point. This joined-up approach to business clearly plays well with clients. "What we are doing is sharing our intellectual capital with our clients," says Ms. Pinnavaia.

This is the answer to the key question of how GSHFS flourishes within the context of the bank. The fund of funds unit is leveraging the knowledge base and best operating practices of the parent to the apparent benefit of the client. The time spent with clients facilitates a two- way dialogue, and the client base can feel they have the opportunity to tap into the intellectual capital. This should give some longevity to the relationships provided there are not too many clients to nurture. The early evidence is good, as that part of the client base that were early movers into hedge funds are using GSHFS to implement the evolution away from broad diversified products into customisation and niche investments. A commercial strategy well executed.

Nadja Pinnavaia

Ms. Pinnavaia is Head of Hedge Fund Strategies, Europe and Asia. Ms. Pinnavaia joined Goldman Sachs in 1995 where she worked within the Equity Derivatives group, responsible for the development of the derivatives business involving UK and Italian institutions. She subsequently moved to the Investment Management Division, focusing on Wealth Manage-ment for Ultra High Net Worth Individuals. Prior to assuming her current role, Ms. Pinnavaia was Co-Head, Hedge Fund Strategies, Europe, responsible for hedge fund manager selection across Europe and Asia, with a particular focus on Equity Long/Short managers. Ms. Pinna-vaia became a managing director in 2004. Prior to joining the firm, she earned a Ph.D. in Quantum Chemistry from St. Catharine's College, Cambridge University in 1994, and her Bachelor of Science in Chemistry from King's College, London in 1991.