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October 2019 | GSAM Connect

Finding Alternatives in Today’s Market

Against the backdrop of a potential for recession, flare-ups of market volatility, and political shocks, we believe alternatives may help investors generate additional sources of return, and reduce volatility. In an in-depth interview, Natalie Kennelley and Oliver Bunn from the GSAM Quantitative Investment Strategies Portfolio Management team discuss how alternatives may help investors navigate today's markets.

Q: What can investors do to navigate potential volatility?
We believe that alternative investments, both private placements as well as alternatives in liquid form, are an incredibly useful tool for smoothing out the ride so that clients can ultimately stay in their seats during bouts of volatility. A big reason why alternatives are such a useful tool is because of how they behave when equities and fixed income face challenging environments.

Since 1990, alternatives, as measured by the Hedge Fund Research Fund of Funds Index (HFRI FoF), have outperformed equities by 23% on average during periods of bear markets or large drawdowns. Additionally, alternative investments have outperformed core fixed income during periods of rising interest rates by 15% on average. Historically, alternatives have demonstrated the ability to provide a source of outperformance versus either stocks or bonds nearly half of the time.

Source: HFR, Bloomberg, GSAM. Time period shown is earliest common inception date (HFRI FoF inception 1/1/1990) through 12/31/2018. Rising rate periods are longest five since 1990. Bear markets are defined as periods in which equities realized at least a 15% pullback. Challenging environments are equity bear markets and rising rate periods. S&P 500 Index = S&P 500 TR Index. GROWTH OF $100: A graphical measurement of a portfolio's gross return that simulates the performance of an initial investment of $100 over the given time period. The example provided does not reflect the deduction of investment advisory fees which would reduce an investor's return. Please be advised that since this example is calculated gross of fees the compounding effect of an investment manager's fees are not taken into consideration and the deduction of such fees would have a significant impact on the returns the greater the time period and as such the value of the $100, if calculated on a net basis, would be significantly lower than shown in this example. Past performance does not guarantee future results, which may vary.

Q: Can you discuss hedge fund performance given the market backdrop?

In 2018, the U.S. equity market was down about 4.4%, while global equities were even worse, down 8.7%. If emerging markets are included, equities were down 9.4%.1 That was an environment when hedge funds, measured by the HFRI Fund Weighted Index, were only down 4.7%, which provided a nice cushion compared to global equities.

In comparison, hedge funds were only up 7.4% through August 2019 while equities were up 18%, 15% and 14% across the U.S., global and emerging markets, respectively. However, it’s crucial for us to also take a deeper dive into the more volatile times this year, which are May and August in particular. In May, U.S. equity markets dropped more than 6%. Hedge funds on the other hand were only down 2%, which provided a nice cushion.

A similar situation occurred in August 2019 as the S&P 500 Index was down 1.6% and global equities were down 2%, while hedge funds were only down 60 basis points. This demonstrates that alternatives have actually been able to somewhat protect investors over just investing in equities during volatile times.

Q: Can you talk about your recent observations on hedge fund performance across different categories?

In 2018, the Equity Hedge category was the worst performer and was down more than 7%. In comparison, Relative Value was almost flat for the year, while Event Driven was down 2% and Macro was down 4%. Fast forward to 2019 year-to-date (YTD) through August, Macro is actually the category that turns out to have had the best performance with gains of 10%. That is now followed by Equity Hedge (with returns of 8%) which was the worst performer in 2018. Relative Value and Event Driven are up 5% each as well but are up substantially less than the performance of other categories.

This tells us that it continues to prove very, very difficult to forecast or time exposure to individual alternative styles.

Q: Can you share some of the research that you’ve done on individual manager persistence?

We conducted a long-term persistence study spanning data from 2003 to 2016, and looked at the top 20% of hedge fund performers in any given year and measured where they were likely to rank in the following year. Less than a third of these top quintile performers in one year are likely to repeat a position in the top 20% just one year later. Additionally, almost a fifth of the top performers in one year are likely to end up in the bottom quintile in the next year instead.

If we focus on the more volatile environment of 2018 and 2019 YTD, the numbers are even more pronounced. Only 10% of fund managers were able to repeat in the top 20% for 2019 YTD, with a fifth of the funds ending up in the bottom 20% instead.

Overall, as these examples suggest, our findings indicate little evidence of performance persistence over time.

Q: Can you share how you think about investing in your alternatives program?

We take a diversified and varied approach to deliver hedge fund-like returns without directly investing in hedge funds. We do not invest in any hedge funds or external managers directly, instead we employ a wide range of liquid instruments, spanning for example single name equities, ETFs, futures, FX forwards and others.

We are looking to provide exposure to all the four main hedge fund styles: Equity Long Short, Macro, Relative Value and Event Driven.

We invest in a diversified bundle of liquid hedge fund market exposures and trading strategies by using our knowledge of the hedge fund industry and our data sources and technology. Our hedge fund knowledge comprises many individuals that have worked at hedge funds, have closely interacted with hedge funds or have been engaged in trading activities. This expertise and knowledge put us in a position to really get to the bottom of the systematic drivers of hedge fund returns. We then complement these fundamental insights with a range of data sources, including hedge fund return databases, prime brokerage reports, hedge fund consultants or public hedge fund filings such as 13-F, etc.

[1] Source: Bloomberg. Indices referenced are US: S&P 500; Global Equities: MSCI World Index; Including Emerging Markets: MSCI ACWI Index

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September 2019 | Market Know-How
Easy Does It

We see current conditions as largely benign as long as investors understand that risk may no longer be linear. Political shocks and policy-related risks are the variables to watch, whereas we see recession risk as still moderate.