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MONEY MANAGEMENT - Inside the Mint

Goldman Sachs Asset Management has coined money for years. After a subpar 2006, can it restore the luster?

  • Jo Wrighton

Goldman, Sachs & CO. ANALYSTS PUBLISHED A PIVOTAL report in 1995 predicting that within a few short years the money management business would be dominated by a few giant firms, alongside scores of specialist boutiques. The Goldman analysts declared that big fund managers would need at least $150 billion in assets to survive. At the time, just nine firms in the U.S. had that much.

The report sparked a widespread rethinking of the business as firms scrambled for a place among the top tier. Some of Goldman's biggest rivals led the charge, including Morgan Stanley, which acquired Van Kampen American Capital in 1996, and Merrill Lynch & Co., which bought the U.K.'s Mercury Asset Management in 1997.

But no firm, seemingly, took the report's conclusions more to heart than Goldman itself. From $46.3 billion in assets and a 52nd-place slot in the 1995 Institutional Investor 300 ranking of the biggest money managers, Goldman Sachs' asset management business climbed to No. 14 last year and at the end of February oversaw $719 billion. A cool $147 billion of those assets are in highly lucrative alternative investments: Goldman now ranks as the world's biggest manager of hedge funds even as it runs one of the biggest private equity fund-of-funds operations in existence.

Overall, Goldman's asset management division attracted a stunning $94 billion in new money last year, more than twice its assets under management in 1995. And the firm is still hungry.

"We've got even more growth to come," asserts a confident Eric Schwartz, 44, a onetime co-head of equities at Goldman's investment bank who now runs the asset management business with Peter Kraus, 54, a former top deal maker who also hails from the firm's investment bank.

Goldman's money managers figure that over the next five years they can double the $102 billion they oversee in quantitatively managed equity portfolios, partly by selling new funds that invest in emerging markets and other new products. They also aim to double the $213 billion they manage in fixed-income securities by aggressively targeting insurers and wealthy individuals seeking absolute-return and municipal bond strategies. And Goldman Sachs Asset Management's co-heads plan to keep pressing the accelerator in the hedge fund business by adding strategies and recruiting traders like the 18 credit specialists they hired in December from collapsed hedge fund Amaranth Advisors.

"Goldman is deadly serious about building the premier asset manager for institutions and individuals in the world," says Philip Murphy, co-chief of the investment management division from 2001 to 2003 and now national finance chairman at the U.S. Democratic Party.

Along the way, Goldman has earned the envy of competitors for its prodigious, money-spinning ways. Last year, thanks to booming sales to institutions and wealthy individuals, the asset management division posted record net revenue of $4.29 billion. (Goldman does not break out profits for the unit.) By contrast, Legg Mason, with $945 billion in assets, produced just $2.65 billion in revenue. The reason for Goldman's greater punching power: those alternative investments. Almost a quarter of Goldman's asset management revenues, or $962 million, came from incentive fees.

Rivals have gotten the message in the midst of the latest of the periodic upheavals that sweep through the business. Some big houses have thrown in the towel on traditional asset management: Citigroup sold its money management arm to Legg Mason, Merrill Lynch merged its business with BlackRock's, and American Express hived off its own in an IPO. Others, like Morgan Stanley and Lehman Brothers, are closely following Goldman's lead, aggressively acquiring stakes in hedge fund firms. Last month Lehman bought 20 percent of leading quantitative hedge fund firm D.E. Shaw & Co. for an undisclosed sum; the deal was led by George Walker, GSAM's former head of alternatives, who was poached last May by Lehman.

Yet for all its stunning successes, Goldman has stumbled of late, tarnishing its reputation and grandiose ambitions. Most notoriously, Global Alpha, its star hedge fund and fee-making machine, suffered a miserable 2006: After a 39.9 percent gain in 2005, the $12.5 billion-in-assets fund fell 6 percent last year compared with an 8.14 percent gain for the Hedge Fund Research macro index that tracks similar strategies.

Global Alpha's miseries earned Goldman unwanted headlines, but the problems run deeper. Also suffering are Goldman's global tactical asset allocation portfolios, lower-risk versions of Global Alpha­like trading strategies that are aimed at institutional investors, such as pension funds and endowments. The firm's GTAA portfolios, which had $55.8 billion in institutional assets as of December, also ended the year in the red, losing 2.51 percent on average after fees, according to composite return figures supplied by Goldman. And the firm's quantitative stock pickers underperformed their benchmarks in both U.S. large-cap and small-cap stocks. These problems come on the heels of continuing low returns in GSAM's actively managed global equities division despite a management shake-up that began two years ago.

"The active global equity space," concedes Kraus, "has been the toughest place for us to get performance right."

So far Goldman's glittering brand, strong quant pedigree and solid long-term track record have helped the firm win a remarkable amount of new business, even in a tough year. But a prolonged downturn in performance would almost certainly translate into outflows.

Some cracks are beginning to show. Earlier this year the $26 billion Arizona State Retirement System terminated its $1.4 billion GTAA mandate. Arizona had concerns about Goldman's "organization/business model, their investment process and performance," chief investment officer Gary Dokes told an investment committee meeting, according to minutes posted on Arizona's Web site. (An Arizona spokesman declined to comment.)

The recent performance stumbles have hurt more than Goldman's pride. In an otherwise sparkling performance by the firm in its fiscal first quarter, ended February 23, overall revenue from asset management fell to $1.07 billion, down 28 percent from the year before, despite net inflows into stock and fixed-income funds that bolstered management fee revenue. Incentive fees took a dramatic hit, dropping to $90 million from $739 million in the same quarter last year, mostly as a result of the losses that were posted by the quantitative strategies team. Like most hedge funds, the Global Alpha and GTAA portfolios charge management fees and take about 20 percent of the profits. But they also have high-water marks and thus must recoup last year's losses before the incentive fees begin flowing again.

Mark Carhart, co-head of GSAM's quantitative strategies team, blames the performance setbacks on economic uncertainty. "When there is a change of direction, that tends to hurt us," says the 41-year-old former University of Southern California assistant finance professor, who was recruited by Goldman in 1997. "The second half of last year and the first quarter of this year could be seen as a period of transition in global macro markets."

Perhaps. But could there be another explanation? Has the world's largest overseer of quantitatively managed global macro funds gotten too big? Size is an issue for these funds because big positions in high-risk, high-return asset classes like emerging-markets currencies become difficult and expensive to manage.

"It becomes a constant battle to find new sources of liquidity and better ways of trading," says Alistair Lowe, the Boston-based head of global asset allocation and currency at State Street Global Advisors. "A good manager will be prepared to turn away new business to protect their existing clients."

GSAM executives contend that size did not affect their returns in global macro strategies last year and insist that the current missteps are merely a temporary function of the markets. "Nothing is broken," says co-head Schwartz.

Nonetheless, GSAM is making some adjustments. The firm closed its Global Alpha fund to new investors more than a year ago because of capacity concerns in strategies like volatility trading. And late last year the quantitative strategies group switched from monthly to daily trading "to react more quickly to changes in market direction," says Carhart. The quantitative strategies co-head adds that the firm will likely close its GTAA portfolios to new investors in the next few years.

Of course, size brings other challenges. Although the firm's entrepreneurial culture and highly motivated and talented people have helped drive the growth of the asset management operation -- as they have Goldman's trading and investment banking divisions -- that motivational edge is harder to maintain as the business get bigger.

"Can all of our people maintain the same aggressive posture and keep the same drive and ambition to do more and better for our clients?" asks Schwartz. "That's a key question."

GOLDMAN SACHS ASSET MANAGEMENT REPRESENTS THE investment bank's second foray into the business of managing money. In the late 1920s the firm launched Goldman Sachs Trading Corp., an investment trust that imploded in the stock market crash of 1929 and blemished Goldman's reputation for years.

In the decades that followed, competitive concerns chilled Goldman's money management ambitions. Even as such rivals as Morgan Stanley, Merrill Lynch and what was then First Boston expanded into the business, the heads of the firm's equity division resisted, fearing that such a move would be perceived as a threat by asset manager clients and harm Goldman's brokerage operation.

"We couldn't reach a consensus, so we didn't proceed," says Alan Shuch, an early champion of money management who once ran Goldman's global bond sales and in 1988 became GSAM's first president and chief operating officer. Shuch now serves as an advisory director to Goldman.

The tipping point came in 1987, when the stock market crash sent senior partners Stephen Friedman, Robert Rubin and John Weinberg scrambling for fee-generating businesses to counter volatile trading profits. By then Goldman's top competitors were already active in money management, and the firm's brokerage business was considered less at risk.

Goldman Sachs Asset Management was launched the following year with about $11 billion in money market assets that had once belonged to Institutional Liquid Assets, a money manager that Goldman had acquired in 1981 and that had reported to the fixed-income group then run by Mark Winkelman and Jon Corzine, now the governor of New Jersey.

It didn't take long for GSAM to notch a few big wins. After the operation added $1 billion in fixed income from blue-chip clients like American Airlines and General Electric Co. within a year, Leon Cooperman, Goldman's highly regarded head of research, was made CEO and charged with expanding into stock funds. At about the same time, Robert Jones -- a research analyst in the investment bank working on quantitative models -- convinced Goldman client Bell Atlantic Corp. to let him manage $100 million in U.S. equities. Armed with the mandate, he persuaded Cooperman to bring him over to GSAM to launch a quantitative equities group.

Cooperman wanted to manage hedge funds, but Goldman's management committee turned him down. Senior partners feared a repeat of the bad publicity surrounding Goldman's controversial Water Street Corporate Recovery Fund, which was launched in 1990 and aggressively invested in junk bonds and other debt of companies in financial difficulty, including some of Goldman's former investment banking clients. The fund shut down within a year after the firm's investors and clients complained about potential conflicts of interest. Goldman's partners feared that Cooperman's plan to launch hedge funds, including a merger arbitrage fund, could cause similar controversy.

Chafing under the restrictions, Cooperman quit Goldman in 1991 to set up his own hedge fund business, Omega Advisors. GSAM's ambitions remained modest until bond markets tanked in 1994, once again spotlighting Goldman's dependence on volatile trading profits and its need for more-reliable recurring fees.

In 1996, John McNulty, who had begun his Goldman career as an adviser in the private wealth management business, became a co-head of GSAM, along with David Ford, who had been appointed in 1994. McNulty led an aggressive expansion drive, and this time Goldman was more willing to consider hedge funds. "The game plan before McNulty was burdened by caution," says Shuch. "He was a persuasive force who highlighted the potential of asset management."

Goldman's highly regarded quantitative operation -- today one of GSAM's key growth drivers -- began gathering force under Ford and McNulty. Shortly after being tapped to help run GSAM, McNulty started selling Global Alpha, GSAM's first hedge fund, which was seeded with $10 million in capital from Goldman. The fund was designed and overseen by Clifford Asness, who holds a doctorate in finance from the University of Chicago and had been hired some years earlier.

McNulty also looked outside Goldman for growth. In 1996 he purchased British pension fund manager CIN Management, which added $23 billion in assets, and Tampa, Florida­based growth equity manager Liberty Investment Management, which oversaw $6 billion in assets. The following year, in a truly inspired move, he snapped up Princeton, New Jersey­based Commodities Corp., a managed-futures specialist that ran about $1.6 billion. The operation had been the training ground for star hedge fund managers like Bruce Kovner and Paul Tudor Jones II and became the backbone of Goldman's fund-of-hedge-funds business. Called the Hedge Fund Strategies Group, it today manages $18.1 billion and is the 12th-largest multimanager operation in the world, according to the latest survey by Institutional Investor's sister publication, Alpha.

While McNulty was making acquisitions, Global Alpha was notching impressive results. In a little more than two years, the fund raked in $560 million in assets and delivered enviable returns: 74 percent gross annualized returns with 17 percent annualized volatility and a low correlation to the Standard & Poor's 500 index.

But the quantitative strategies group was soon plunged into turmoil. In January 1998, Asness left Goldman to set up his own firm, Greenwich, Connecticut­based AQR Capital Management. He took nine Goldman people with him, leaving only a handful of junior members and two senior members of the quantitative team that he knew from the University of Chicago and had recruited the previous year: Raymond Iwanowski, formerly a fixed-income analyst at Salomon Brothers, now part of Citigroup, who had left before completing his Ph.D.; and Carhart, who earned his doctorate and studied under Eugene Fama, the academic credited with developing the Efficient Market Hypothesis, which holds that stock prices reflect all known information.

Robert Litterman, Goldman's head of risk management, was called in to head up a new group, quantitative resources, that included the team. "It was a significant loss," he says of the mass defection. But within months Carhart and Iwanowski were put in charge, and they quickly set about rebuilding the operation, hiring three senior staffers in their first year at the helm.

Despite McNulty's growth drive, GSAM was barely profitable. In a bid to sell more of its products through the high-net-worth channel, Goldman put its asset management and private wealth businesses under a new umbrella division, called investment management, shortly before the firm's 1999 initial public offering. McNulty became head of investment management and oversaw an expanded senior team. Philip Murphy, a former head of Goldman Sachs in Asia, returned to New York to head wealth management, and David Blood, a Goldman veteran, joined Ford as co-head of GSAM.

McNulty and Murphy shifted Goldman's private wealth division away from its brokerage roots and toward a more profitable, fee-based business where Goldman advisers allocated assets and constructed portfolios. They also adopted an open-architecture model and began selling other firms' funds. The shift proved painful, as up to 100 old-style brokers left the firm, but the private wealth division hired aggressively to replace them with new advisers. At the same time, McNulty and Murphy boosted sales of GSAM funds by improving service, adding hedge funds and expanding the range of private equity funds.

But GSAM was still barely making a profit by the time McNulty retired in 2001. He was succeeded by Murphy and Peter Kraus, the former head of the financial institutions group at Goldman's investment bank who had engineered such deals as the $16 billion acquisition by Fleet Financial Group of rival BankBoston Corp. and the $22 billion purchase of General Re Corp. by Warren Buffett's Berkshire Hathaway. Kraus had also played a key role in Buffett's unsuccessful attempt to team with Goldman and insurer American International Group to buy part of hedge fund Long-Term Capital Management after it collapsed in 1998.

One of Kraus and Murphy's first decisions as co-heads of investment management was to close Goldman's struggling online venture for wealthy clients, GS.com, and merge that business into the firm's private wealth division. The two also cut administration costs in a bid to improve profitability while continuing Goldman's push into alternatives.

Kraus, who has a BA in economics from Trinity College in Hartford, Connecticut, and an MBA from New York University's Stern School of Business, mixes easily with the firm's roster of private wealth clients, which includes 43 percent of the Forbes 400 list of the richest Americans. Collectors and patrons of contemporary art, Kraus and his wife, Jill, have helped fund works like Robert Smithson's Floating Island to Travel Around Manhattan Island, a barge landscaped with earth, rocks, trees and shrubs, and Jonathan Borofsky's Walking to the Sky, a 100-foot-tall, seven-ton sculpture they gifted to Carnegie Mellon University in Pittsburgh. Kraus's farm in upstate Dutchess County, New York, doubles as a private modern-sculpture park.

Murphy retired in 2003, clearing the way for Schwartz's appointment as co-head of investment management by Goldman's then-CEO, Henry Paulson Jr., now U.S. Treasury secretary. He and Kraus were given direct responsibility for GSAM.

Schwartz, like his co-head, came from outside money management. One of the first in his family to attend college, he earned an engineering degree from the University of Pennsylvania and an MBA from the Wharton School. He became a partner at Goldman at 31 after making a name for himself in the equities division by structuring the first overnight convertible transactions for companies like Apple Computer and Microsoft Corp. In a reflection of his stature within the firm, Schwartz was tipped as a possible deputy to Lloyd Blankfein when the latter was promoted to CEO in 2006. Since 2005, Schwartz has served as co-chairman of the powerful committee that selects new Goldman partners.

TODAY, KRAUS AND SCHWARTZ RUN A GLOBAL FRANCHISE. According to the most recent figures available, nearly two thirds of GSAM's assets come from the Americas, with the remainder coming mostly from Europe, the Middle East and Africa but also from the Asia-Pacific.

GSAM sells its funds through Goldman's own sales force, its private wealth management group and third-party distributors such as broker-dealers like Edward Jones in the U.S. and Deutsche Bank in Germany. It boasts a well-diversified client base. As of year-end 2006, the operation managed $298.3 billion in institutional assets, $123.9 billion in high-net-worth assets and $205.4 billion in mutual funds. (The remainder of Goldman's assets under management come from its merchant banking unit and funds from its private wealth division that are invested in non-GSAM products.)

In one of their first moves as co-heads, Schwartz and Kraus formalized GSAM's structure as a federation of distinct investment boutiques organized by asset class and subdivided by investing style, from funds of hedge funds and quantitative macro strategies to growth stocks and fixed income. Each of the boutiques -- there are now 11 -- is charged with competing against the best firm in its respective area. GSAM's fixed-income business measures itself against bond houses BlackRock and Pacific Investment Management Co. rather than, say, Lehman and Morgan Stanley.

The GSAM boutiques have their own heads or co-heads and dedicated research teams. The heads report directly to Kraus and Schwartz and run their businesses independently -- for example, they form their own opinions on investment trends, make their own stock market forecasts and decide whom to hire and fire on their respective teams.

GSAM's co-heads encourage the boutiques to launch their own hedge fund strategies alongside long-only offerings. A case in point is Robert Jones, who still runs the quantitative equities team. His group has set up two hedge funds in the past four years, one investing in North American stocks and one that plays global equity markets. Jones plans to add another that invests in emerging markets.

"Virtually all our businesses can stand on their own," says Kraus.

GSAM also has a separate alternatives division, led by Mark Spilker. The group comprises Hedge Fund Strategies, the boutique that invests in funds of hedge funds and oversees $18.1 billion; its Private Equity Group, which has $20.8 billion; and Global Manager Strategies, which runs long-only funds of funds for private wealth clients that invest in both proprietary and external products and has $37.5 billion in assets. The hedge fund team that Goldman hired from Amaranth also reports to Spilker.

This boutique system allows the GSAM co-heads to hold each entity accountable for performance and to reward those that produce the best returns. Half of the bonus of portfolio managers on the New York­based value equity team, for example, is determined by their individual performance, while the rest is based on how well the value portfolios perform overall. Previously, bonuses were based on GSAM's performance as a division.

"We feel like a small firm," says Eileen Rominger, head of the value equity group, which oversees $25 billion and manages highly rated midcap value funds. "There is a tremendous sense of ownership."

Though autonomous, the boutiques share marketing and distribution resources, including a growing army of salespeople in the U.S., Europe and Asia that now totals about 500 -- and keeps the assets flowing in. GSAM's model means that its boutiques effectively compete with one another for shelf space and must make an effort to stay top of mind with the sales force.

"It's not as much fun during bad times," admits quantitative equities chief Jones.

The quantitative resources group, which includes both global macro strategies and equities, manages about $200 billion. This group has experienced some of the fastest growth in recent years and represents one of the largest pools of capital within GSAM. The division is also at the heart of the firm's recent slipups, which are symptomatic of the broader woes that quant investors encountered last year and in the early months of this year as a result of low volatility and a lack of clear trends and themes in global markets.

Jones manages 70 investment professionals who run $102 billion in institutional funds, mutual funds and hedge funds using computer models that forecast the expected return on 8,500 stocks globally and aim for steady outperformance. The models are based on six investment themes: valuation, profitability, earnings quality, management impact, momentum and analyst sentiment.

GSAM's quantitative stock funds have outperformed over the long term. But last year the team had a tough time in U.S. equities. The firm's biggest large-cap institutional offering, the $10.7 billion Structured Large Cap institutional portfolios, returned on average 14.29 percent after fees, versus the 15.79 percent return of the S&P 500 index -- the first time the strategy had fallen short of the benchmark since 1998. These funds invest in between 60 and 350 stocks and aim to outperform the index by 100 to 170 basis points annually.

The team's small-cap funds also took a hit. The institutional Structured Small Cap portfolios, which have $2 billion in assets, returned 13.22 percent on average after fees, compared with the 18.37 percent return for their benchmark, the Russell 2000 index.

"Our models did not work well, especially the momentum and earnings quality factors," says Jones. A speculative rally in U.S. stocks from August to November was especially damaging. Companies with "negative earnings, no dividends and optimistic growth expectations saw their prices jump," he explains, and that hurt relative performance.

GSAM wasn't the only firm to report difficulties in U.S. stocks. "Last year was not a great year, because of low volatility," says Arlene Rockefeller, head of global equities at SSgA in Boston, whose U.S. large-cap quant funds beat the S&P 500 but fell short of their return target of 300 basis points above the index.

The GSAM quantitative strategies team that oversees Global Alpha and the GTAA portfolios also had a tough year -- but not for lack of brainpower. The 75-person group, run by co-heads Carhart and Iwanowski, includes roughly 15 Ph.D.s. Every week they invite an outside speaker to give a talk before lunch on subjects ranging from earnings anomalies to accounting issues. In March one of the guests was Vish Viswanathan, professor of finance at Duke University's Fuqua School of Business, who discussed trading. In other internal seminars members of the team present new research to the rest of the group.

"The idea is to have critical minds asking questions," says Carhart.

These days those questions are likely centered on what has been going wrong. Global Alpha's 6 percent loss last year, for example, was largely the result of underperformance in August, September and October. "Previously, we had low inflation and consistent global growth -- and suddenly, we saw a significant decline in oil prices and the Fed and other central banks declining to raise interest rates," explains Carhart, who says that his global macro strategies delivered a strong performance in December and January but that February was again weak.

Quantitative strategies is a complex operation. The team employs 25 different macro trading strategies with varying levels of risk. Global Alpha uses all of these strategies and has a high annualized volatility of 17 percent. The GTAA funds for institutions invest only in the five most liquid strategies in developed markets spanning fixed income and equities, so the end product has average volatility of just 2 to 3 percent a year.

"We run an alpha factory," says Iwanowski.

The group manages $55.8 billion in GTAA institutional accounts and the $12.5 billion in Global Alpha, which is mostly for wealthy individuals and Goldman employees. The team also oversees about $21 billion in global equity overlay strategies, $15 billion in currency overlays and some $8 billion in quantitative fixed-income products. All of their macro strategies use derivatives to gain exposure to the markets and employ some leverage.

Carhart and Iwanowski can tailor their portfolios to the needs of individual clients, changing the level of risk, the benchmark or the benchmark currency, for example. They can also offer dynamic risk management in certain products. "We can dial down the risk if a portfolio gets close to double-digit losses in products that are designed to have this level of drawdown control," says Carhart.

The team's strategy that goes long and short stock indexes in the developed world illustrates the approach. GSAM's computer models seek countries that are cheap as measured by stocks' price-to-earnings or price-to-book value, where there is strong price and earnings momentum and where the market has underestimated macroeconomic growth. The models also incorporate investor sentiment by measuring fund flows and investors' perceptions of risk, for example.

"The more risky the perceived risk, the higher the expected return," says Carhart. Early this year his team was long stock markets in Japan as well as many European countries but short the U.K. and U.S.

Global Alpha uses the same five strategies as the GTAA funds, along with 20 other strategies, including investments in stocks, bonds and currencies in emerging markets as well as volatility and dispersion trades.

Funds like these that employ global macro trading are volatile. "They're taking big bets," says Stephen Wiltshire, chief investment officer for Europe at Russell Investment Group in London. "These are long-term strategies."

Goldman's institutional GTAA funds were up an annualized 3.64 percent on average for the five years through December 2006 gross of fees, compared with a 1.6 percent return for the GTAA Master Blended benchmark. Goldman won't disclose the performance of Global Alpha, but a rival hedge fund manager who has seen the numbers says that the funds returned 36.1 percent in 2003, 2.7 percent in 2004 and 39.9 percent in 2005 before faltering last year.

Rivals hope to profit from the quantitative strategy team's recent troubles. "If any major competitor stumbles, it always means more people are likely to look around for alternatives," says SSgA's Lowe.

Barclays Global Investors, one of GSAM's top rivals in quantitative investing, is also stepping up the pressure. Early last year the San Francisco­based firm closed its GTAA funds, which have $5 billion in assets and 20 percent annualized volatility, because of concerns about capacity. But it has since reopened them with improved models and new strategies, such as commodities investments, says Michael O'Brien, head of the firm's European institutional business. Last year, while Goldman's GTAA portfolios were losing money, BGI's returned 11.9 percent gross of fees.

"Goldman and other firms have had a free run," O'Brien says. Still, he concedes that GSAM is a formidable competitor. "You can't write them off because of one bad year."

ELSEWHERE IN THE GSAM EMPIRE, THE FIXED-INCOME team led by Jonathan Beinner, 40, and Tom Kenny, 44, has delivered strong results. The division boasts $213 billion in assets, compared with $50 billion five years ago, and has grown through sales of hedge funds and mutual and institutional funds that invest in both investment-grade and non-investment-grade corporate and government bonds. Last year's strong performance in emerging-markets debt strategies helped double funds under management in that asset class, to about $3 billion.

"We think we have a robust investment process, a good long-term track record and a stable team," says Beinner, who joined Goldman in 1990. "We are big enough to be able to afford a team of more than 130 people, but we're not so big that we can't take advantage of the investment ideas we develop."

The fixed-income group's flagship hedge fund, launched in 2001, has about $3.5 billion in assets and provides exposure to all of the group's 19 different active investment strategies. The fund invests in macro strategies, betting on the direction of interest rates, for example, as well as on individual securities like mortgage-backed and high-yield bonds. Roughly two thirds of the hedge fund's assets come from wealthy individuals, and the remainder is institutional money.

The rest of the group's fixed-income products are subsets of the active strategies. GSAM's Core institutional and mutual funds, for example, invest in global investment-grade corporate and government bonds; its Core Plus funds invest in these asset classes but add exposure to junk bonds. GSAM manages about $25 billion in assets in these strategies and thinks it can grow them fivefold over the next three to five years. That's still below the roughly $282 billion that rival Pimco manages in its flagship Total Return strategies.

GSAM's Global Emerging Markets Debt portfolios for institutional investors have been standouts. The funds returned 12.32 percent on average last year net of fees, versus 9.86 percent for their benchmark, the JPMorgan EMBI global diversified index. Over three years the funds topped the index by 477 basis points.

Beinner and Kenny say they are targeting growth from all areas but especially from insurers looking to outsource asset management. (GSAM currently manages about $30 billion in insurance assets.) They also expect Goldman's private clients to continue pouring assets into tax-exempt municipal bonds, which are Kenny's specialty. Since he joined GSAM in 1999 from Franklin Advisers, where he was head of municipal securities, the fixed-income boutique has grown its muni securities under management to some $23 billion, up from just $1 billion. GSAM now runs the largest fund investing in high-yield muni bonds in the world, with about $7 billion in assets.

Hedge funds are another growth area. Beinner and Kenny expect to add about $4 billion with new launches in the next couple of years in such areas as emerging markets and commodities. "The more strategies you have, the more business opportunities you have," says Kenny.

In stark contrast to the fixed-income business, Goldman's London-based, actively managed global equity team, which oversees $20 billion, has struggled over the past few years. At the end of 2004, Kraus and Schwartz moved to fix the performance problem by hiring a new head: Mark Beveridge, a former global equities manager at Franklin Templeton Investments.

His effort is still unfolding. "Things are looking favorable, but it will take between three and five years before we can tell with any certainty," says Beveridge, 45.

When he first arrived, GSAM's emerging-markets products were doing well, but its global, European and Japanese equity strategies were all underperforming their benchmarks. The new global equities head quickly diagnosed a structural problem: a lack of overall control. Each region had its own chief investment officer, and analysts didn't formally share ideas among regions.

Beveridge soon had everyone reporting to one chief investment officer -- himself. He took control of investment philosophy, setting up twice-weekly global research conference calls so that analysts covering the same sectors in different regions could share ideas. The philosophy, he says, emphasizes companies that are undervalued by the market and offer strong, long-term earnings power.

Since Beveridge took over, half the ten-person team has changed in Japan, where GSAM manages about $48 billion and ranks as one of the largest foreign fund managers -- and he is looking for more hires. The global equities chief is also planning to add research analysts to a three-person team in China. GSAM already has one portfolio analyst in South Korea, and Beveridge recently hired a head of research in Mumbai, bringing the head count in India to five.

In Europe, Beveridge's diagnosis was that the research team was not "hunting for alpha." Last May he brought in a new co-head of pan-European equities, Heather Arnold, a former portfolio manager from Franklin Templeton. Arnold repositioned the European portfolios at the beginning of August; through mid-March they outperformed their benchmark, the euro-denominated MSCI Europe unhedged index, by more than 500 basis points.

Beveridge has also revamped the global equities team. The group suffered from a lack of input from the different regions, he says, so he converted generalist portfolio managers into sector specialists led by William Howard, another former Franklin Templeton portfolio manager, who joined Goldman at the end of 2004.

Last year GSAM won several international mandates from U.S. and Japanese clients. Since Beveridge took the reins, the London-based emerging-markets team has won seven institutional mandates, increased inflows into its mutual funds and launched two new products. The team now manages more than $4 billion.

Some clients are noticing the difference. Beveridge has "reinvigorated the whole process," says William Hale, a senior investment analyst at Lincoln Financial Group in Barnwood, Gloucester, in the U.K. Lincoln Financial has about £2 billion ($3.9 billion) invested in Goldman's global funds.

Performance, however, remains mediocre, and asset growth has been flat under Beveridge's tenure. Among its institutional portfolios, GSAM's Strategic International Equity strategy, which has about $804 million in assets, returned 24.99 percent on average net of fees last year, compared with the 26.34 percent return of the MSCI EAFE index. The European Strategic Equity portfolios, which have $1.7 billion in assets, and the Japan Strategic Equity portfolios, which have $651 million, also underperformed their benchmarks in 2006.

For now GSAM co-heads Kraus and Schwartz remain sanguine about these and other setbacks in their much-envied global money management franchise. Of course, Goldman's strength lies not only in its ability to constantly reinvent itself by launching new products and nurturing talent but also in moving quickly to fix problems. Nonetheless, GSAM's management duo isn't contemplating any changes to Global Alpha -- the strategy that has caused the most headline risk -- and the GTAA portfolios, their less volatile institutional counterpart. "Clients bought into a process that is disciplined and unemotional," says Schwartz. "They would be more worried if management tinkered with the investment process."

Given the fierce competition for mandates and pressure to deliver, it won't take long to see if this hands-off approach is the right call.