Introduction
Hedge funds are private investment funds, viz. they are a collection of money, obtained from investors by a certain designated individual known as an investment fund manager. The idea of hedge funds consists in collecting money and then investing it as a pooled resource to earn returns. When profits come in, they are divided amongst the investors according to the percentages of their investments minus the amount they have agreed to pay to the fund manager for the services offered.
Whereas hedge funds have a similarity in regard to mutual funds since they both involve the collective investments of funds pooled by the investors, the two forms of funds differ because the market regulation authorities do not require hedge funds to be registered under the federal securities laws. This requirement is both good and potentially bad because it means that investments can go through hedge funds with a lot of expedition without undue regard to the procedural technicalities required for registered funds. The negative side is that the funds suffer fewer regulations than other securities investments being a risk for investors because they could be easily swindled of their money in a Ponzi scheme (Barwick 36).
The justification offered for the lack of registration is that hedge funds are private entities that investors resort to when they do not wish to have their securities declared to the public. Additionally, most hedge funds are limited to no more than 100 investors at a time. The organization of the hedge funds is in the form of limited partnerships for tax avoidance purposes. This aspect means that there will be a general partner, usually the investment manager, and limited partners, who are the investors.
The manager thus administers the hedge funds. The investors, on the other hand, provide the capital, but they do not have authority in the daily running of the hedge fund. It would secure the investors’ trust if the manager contributed to the capital pool by a certain considerable percentage, as in that case, they would be sure that the manager has interests that she or he will have to protect in the investments. In regards to the remuneration of investment managers, mutual funds offer a restricted reward scheme, which means that the investment manager is only entitled to a percentage of the Assets under Management (AUM).
There is no reward as far as the performance of the fund is concerned, which underscores the difference in hedge fund remuneration. In the latter, the manager is entitled to an incentive fee as well as a percentage (usually 1 per cent or 2 per cent) of the Assets under Management (Cai and Liang 66). The incentive comes when the manager performs commendably as depicted in the increase in profits as well as consistency of returns. This paper explores the hedge fund success story of Renaissance Technologies LLC.
The Renaissance Technologies LLC
The Renaissance Technologies LLC is an investment fund owned by Jim Simons and valued at $20 billion. The investment fund’s main vehicle of trade as per a paper that was circulated to its public are stocks and futures (Burton 25). The headquarters of the firm is situated at East Setauket, New York and one of the perquisites it has to offer is the use of computer software in buying and selling. In any hedge fund, this element is a bonus because it guarantees customers’ efficiency and accuracy in the trading of their investments. When dealing with hedge funds, these two characteristics, viz. efficiency and accuracy, are critical because they ensure that investors’ money is being handled as it should be.
Efficiency, which denotes expediency, ensures that the hedge fund operators are up to speed with the latest investments and that upon the first appearance of an investment option, they are ready to deal. Accuracy is critical because it ensures that the figures are correct and no instances of fraud, whether intentional or by mistake or misrepresentation of figures occur without the administration’s knowledge. This aspect may sound like trivia, but in actual scenarios, this element could be the determining factor of whether a fraudulent broker shall be required to return investors’ money or not (Deloitte 43).
The candidate hedge fund shall be operating alongside Renaissance Technologies LLC’s $7 billion Renaissance Institutional Equities Fund, the $4 billion Renaissance Institutional Futures Fund, and a third fund that strictly serves the firm’s employees. This sort of history provides potential investors with some evidence of the credibility of the firm and its competence in the management of funds. However, potential investors need to look beyond what is issued to the press because that sort of publication rarely contains any dirt on the investment firm. For a more accurate, even clinical analysis, the best source would be the SEC records on the firm’s transactions, both past and present, as well as those required by the provisions of the Dodd-Frank Act on hedge fund operators. Failure to do so leaves investors at risk of becoming victims of Ponzi Schemes.
Strategies
Ponzi Schemes
A Ponzi scheme, named after Charles Ponzi, who was notorious for using the technique, is a fraudulent investment mechanism that features a promoter using investors’ own money or the money of subsequent investors to pay them back. It features high returns that are usually almost immediately after the investment and are paid in relatively subsistent intervals. In other words, Ponzi schemes are pyramid schemes where the investor is lured into believing that his or her money will generate high interests within a short period; to confirm the viability of the scheme, the initial amount is repaid within the agreed time.
As a result, the investors think that their money is being invested profitably and they recommend the firm to other investors who supply money which is used to pay the previous investors’ profit and so on. After the initial payment, the investor is compelled to invest more money after which the schemers vanish with huge sums of money.
The constructed effect is to feed the greed of the investors by creating an illusion of perpetual timely returns, and thus get them to invest more and call their friends to invest as well. The promoter then usually comes up with an elaborate set of plans that ensures that the firm holds investors’ funds for extended periods, which in effect allows the money to earn interest. In case an investor feels dissatisfied with the arrangement, the firm would then process the amounts very deftly; this move gives the impression that the investors’ money is always solvent.
Ponzi schemes are inherently self-destructive, hence they are bound to fail because soon enough, the authorities are informed of the scrupulous conduct through whistleblowers within the firm or other informants including rival firms (Chen and Liang 850). Alternatively, the promoters upon reaching a climax where the investors trust them and/or they are making lump sum deposits, could run off with the investors’ money together with payments that are supposed to be paid to investors in returns in the form of instalments.
Alternatively, the scheme depends on the high deposits made by the various investors in case of a reduction of capital due to a minimal or even large recession, for example, the one experienced by the United States’ economic meltdown in the year 2008, which revealed the myriad Ponzi schemes to the public that were robbing Americans at the time. On the other hand, in case of such a recession, the investors usually cut down on the amount they are depositing and instead begin to ask for more in profits that are similar to a bank run. At such times, the scheme collapses and the fraud is exposed (Deutsche Bank 69).
Consequently, to avoid these occurrences, it has become apparent that the government needs to regulate the market especially in the case of security investments and particularly with hedge funds. In the end, the government has promulgated several legislations in the past few years, such as the Sarbanes Oxley Act and the Dodd-Frank Act. While the Sarbanes Oxley Act is already in operation hence the institution of the SEC, the Dodd-Frank Act is yet to be promulgated completely with a few provisions of 40, which are yet to be proposed and promulgated (Deloitte 43). However, even in its incomplete form, the Act makes a special provision for the administration of hedge funds and it requires capital managers to report to both the SEC and the Dodd-Frank equivalent of the SEC.
Aside from regulation, there is the daily administration of hedge funds and this aspect requires the observance of certain strategies to ensure maximally profitable returns and as few losses as possible. The strategies that are available for investment firms to pick from include correlation strategies, distressed debt strategies, the Madoff strategy, as well as the delta gamma neutral strategy. Most of these strategies shall be analyzed in line with the vignette of the Renaissance Technologies LLC investment firm, but some shall be viewed more closely than others will be before the conclusions, in particular, the beta arbitrage and the Madoff strategy.
Renaissance Technologies LLC has highlighted the fact that it is going to trade in stocks and futures. These are equity instruments and derivative instruments respectively, and so in terms of assets, the foundation is set. Being a business, its incentive is to raise funds. In this field, information is critical to the type of returns that a hedge fund can bring forth. Unfortunately, information or news is unpredictable and so it is not automatic for a fund manager to forecast the direction of securities prices correctly just by looking at the prices of today’s stocks. If this were the case, the collapse of the Long Term Capital Management Firm (LTCM) would be subverted before the Russian crisis.
In addition, it is also true that this position is true for all that seek to trade in securities, and so be they experts in reading securities markets trends or simple investors, in case of a good turn, all benefit generously and equally. Consequently, the obstacle created by risk is somewhat buffered by the generality of the uncertainty; this element reduces the liability of fund managers to some extent.
The new fund, which is the Renaissance Institutional Diversified Alpha Fund, was scheduled to commence its operations in March by participating in the stocks offered by the United States Exchanges as well as futures and forwards available on other fronts. The firm reserves the option of investing in other assets available in the market after a lapse of time has made the trading more stable (Burton 25). In terms of the selection of assets, it is noteworthy that the firm has at least three choices as per the efficient market hypothesis. These choices include the weak form of efficient markets, wherein all the information on the past prices of the assets is included in the current prices and the semi-strong form of efficient markets, whereby all publicly available information, including historical information on the assets’ past prices is included in the current asset prices.
The final one is the strong form of efficient markets that reflect all publicly and privately available information on asset prices. This option is a relative choice and is dependent on the various unique circumstances, surrounding each investment option. It is also notable that part of the name of the new fund includes the term ‘alpha’, which in hedge fund language denotes the highest level of accountability and due diligence required of the fund manager (Burton 25). This element should go a long way in instilling faith in the public that the hedge fund is targeting. Since hedge funds are prohibited from advertising, the only way to spread awareness of them is through word of mouth and consultation as well as quite a lot can be gleaned from the name itself.
Another notable feature of this hedge fund is that it is not going to use any benchmarks. This aspect can be construed either way as it could mean that the firm is striving to avoid the restrictions on the remuneration of the fund manager in terms of performance, based on profits cut, or that it is simply being lax about the returns ceiling, which investors should anticipate or expect from the firm. Either way, the lack of benchmarks is not necessarily a positive thing because it reduces the liability of the firm and the expectations of investors. In such a case, investors also shy from investing in such firms because of the risks involved.
However, this uncertainty may have been counter measured by an incentive that the firm is willing to extend to the investors to take the place of the rigid controls imposed by benchmarks. In this line of thinking, it is no wonder then that the hedge fund proposed ridiculously low management fees. The document proffered to the public quotes a 1 per cent fee on the Assets under Management and a 10 per cent performance fee.
This amount is approximately half of what other hedge funds charge for management, and thus a bonus for investors because it means more returns for them. Leverage is a risk and standard deviation that is not adequately equipped to buffer investors from the possible losses that could accrue due to the use of this strategy. For instance, in affirming that is investing in securities option, the value of these assets could easily depreciate by a hundred per cent overnight, which could be amplified by the leverage resulting in a ripple-loss effect (Patton 2499).
Investors need to be forewarned of the survivor bias malady that ails hedge funds. Once they collapse, they are no longer obligated to give returns, just like when they are performing poorly, they are not required to account for returns. As noted above, it is interesting to follow up on the progress of Renaissance Technologies LLC and the present market figures indicate that the incentive fee and the percentage on the AUM have increased rather ridiculously.
Shortly after they launched the new form, the investors were reeled in by the firm’s successes in the other three funds, including the one that is exclusively restricted to employees of the firm, christened the Medallion Fund that is currently worth over $9 billion and has made consistent returns of about 35 per cent for the past 20 years. As a result, the market was bursting with investors who were willing to gamble their assets through the Renaissance fund and this element meant that the demand was great.
Presently, the firm is charging a management fee of 5 per cent and a profit percentage of 44 per cent. This move is not an easy feat to pull for any hedge fund and, arguably, the lack of a benchmark strategy employed by Renaissance could be the reason for the outrageous fee. However, even in that case, the market requirement for any hedge fund to manage to pull off 10 per cent of its fees from the profits consists in the fact that the returns ought to be at least 23 per cent of the entire fund. At 44 per cent, Renaissance returns must be shooting through the roof and this factor raises doubt on the viability or even legality of their investment strategies. As noted above, the previous litigation has not made provisions for the regulation of hedge funds, but the Dodd-Frank Act is quite clear on the subject.
Introduced in the year 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act is a major actor for anybody operating hedge funds. The sponsors of the bill were Senator Christopher J. Dodd (D-CT) and U.S. Representative Barney Frank (D-MA) and it was intended as a shock absorber, as well as a preventive measure to protect the public from the null effect of a repeat of the 2008 recession. The Act’s specific objectives included the protection of the US consumers from abusive financial services and bringing to an end the concept of “too big to fail” that brought the great losses imposed on taxpayers by the failure of large financial institutions. Others include creating a comprehensive advanced alert system that will prevent retrogressive actions or mere reactions to a failed system (Ferson and Schadt 430).
At its worst, the act ensures that such a system should enable other institutions that are yet unaffected to run for cover, the introduction of transparency to derivatives and other poisonous instruments, such as Over Counter products; it also ensures that they do not contaminate the entire financial system again. In addition, it oversees the making of the credit rating parties more accountable to the public and authorities that they serve, thus ensuring that these parties do not continue to misrepresent investment information, and hence mislead investors, who are seeking out mortgage-backed investments and all other sorts of investments (Carhart 80).
It also grants shareholders a say in the executive remuneration decision making and by so doing ensures that such decisions are favourable to the long term running of the company and do not simply benefit top executives personally (Pastor and Stambaugh 1588).
The Act also sets in motion several regulatory institutions that are similar, but not exact to the Sarbanes Oxley’s Act institution. For instance, where the Sarbanes Oxley Act has a Security and Exchange Commission, the Dodd-Frank Act provides for the creation of a supplementary institution namely the Commodity Futures Trading Commission (CFTC) to work in tandem with the SEC in the regulation of the securities market. An interesting observation of the Dodd-Frank Act is its provisions concerning Hedge funds. This Act goes down as the first legislation to ever institute actual regulations on hedge funds (Franklin 6).
The Act stresses that the CFTC’s jurisdiction extends to both banks and simpler financial institutions, such as hedge funds. As a result, the security market may start noticing some new rules in the application of over hedge funds that cannot be ignored but have to be complied with.
The final sector of this paper is going to touch on the analysis of the strategy before summing up all the information in a conclusion part. It is noteworthy that throughout the paper, the strategies have been discussed in-depth and in detail, and thus those too are applicable. However, the paper boils down to three choice strategies only, in other words, it opts to discuss the Madoff strategy, the alpha strategy, along the Beta Arbitrage.
Beta arbitrage may be considered a simpler method. The idea is that the market absorption or handling capacity for risk is dependent on the type of risks or on how the risk is conveyed to the market (Mamaysky, Spiegel, and Zhang 234). Consequently, for instance, if high beta stocks are overpriced and low beta stocks are underpriced, then one can buy low beta stocks upfront and later short sell high beta stocks for greater returns.
The result of applying this strategy is that the systematic equity risk is going to be minimized whereas the premium earned shall be positive (Dennis and Shepherd 378). Eventually, the aggregate returns for such a portfolio shall be “alpha” and that is how one ensures that he or she gets alpha results. However, this observation is an idealistic scenario and in reality, several risk factors may create the opposite reaction much to the chagrin of investors and the investment firm (Fung and Hsieh 330).
Nevertheless, the fact remains that information is both rare and valuable in securities trading, and unless there is an actual case of insider trading with some individuals being aware of the anticipated market trends in advance, the entire arena of an investment manager and investors alike are going to remain blissfully ignorant up to the last minute. The positive side of having an investment manager though is that such personnel is always more skilled as an expert in the field of trading securities and so his or her bet is more often than not expected to be on the mark.
The thing about risk is that it is a common pedestrian in the corridors of security investments, if one may call so, and to make it worse, investors have policies that are put in place specifically to deter investors from backing out mid investments. They make a withdrawal from the fund in the initial stages almost impossible by requiring investors to sign an agreement, for example, that they will not in any way be in a position to withdraw their capital for the first one or two years of their relationship with the investment fund. Whereas this may seem to be a tricky situation to investors, it is in reality so due to the illiquidity of the investments as procured by such firms (Morrison & Foerstor, 2011).
They invest in many offshore accounts and so the capital may not always be available in liquid cash for withdrawal. Even for seasoned investors who have been partners for decades and now wish to pull out, there are restraints aimed at delaying the process and retrieving the lump sums that are in their capital. However, in the meantime, they can still be receiving their returns in terms of profits and the investment firm can be eager to please and impress any such investor who has shown an interest in pulling out by awarding him or her all sorts of honorary awards in terms of bonuses.
This move may sound unethical, but in essence, it is ‘a necessary evil’ (Linda 432). This assertion holds because if an investor is in a firm that is completely ready to return his or her capital, there are chances that it is a Ponzi scheme. Therefore, the instant gratification derived from the receivership of such capital in no time is aimed at the other active investors as an incentive to reassure them that their capital is always liquid and available.
Another strategy for hedging is “funds for funds” (Fung et al. 1800). This strategy is largely dependent on diversification. It has received much acclamation in the investment arena especially with investors because it cuts down the risk that usually accrues by the usage of leverage. The way it achieves this goal is by diversification of assets within and across the board. The effect of such diversification is to reduce the standard variation index without reducing the investment’s expected return (World Bank 65). It is a safer way than long or short sales and it guarantees similar returns consecutively. This move builds trust among investors and makes some particular firms more appealing and creditworthy. In such a case, more investors pour their money into the firm and, as a result, the firm grows.
A segment that has not received any attention in this paper is the hedge fund–bank relationship. This element is an important one because the hedge funds deposit their money with the banks and at times require credit from banks to top up their available amounts. For decades now, some banks have also been named as investors in various hedge funds and the most notorious investment bank globally is the Barclays Bank (Bollen and Whaley 28). However, similar to other investors, the banks receive no special treatment due to their status and they come in as any other investor. The only noteworthy difference from the rest of the limited investors is their access to information on the hedge fund they are trading in either as the bankers of that hedge fund’s account or through correlations with other banks.
Either way, it gives the impression that in the case of a Ponzi scheme, the bank should beware of defaults way before the scheme collapses unless it is in on it. However, with matters such as the exchange rate variations, banks are as clueless just as the next lay investor is. It is also noteworthy that the Dodd-Frank Act mentioned above restricts banks from having any funds for their gain or profits; if the accumulated returns of such funds supersede 3 per cent of the bank’s total returns, the bank should either dispose of them or shut them down (Guthrie and Parker 160). As a result, many banks shall be turning to hedge funds for investment opportunities shortly.
Conclusion
In the conclusion, it may be stressed that this paper has explored the hedge fund success story with relation to Renaissance Technologies LLC being the investment fund owned by Jim Simons and valued at $20 billion. From the analysis, it becomes clear that the Renaissance hedge fund success story hinges on several aspects that have been employed by the firm in a bid to remain relevant in the market. The investment fund’s main vehicle of trade are stocks and futures; in addition, the firm employs efficiency and accuracy in a bid to earn clients’ trust. The firm employs strategies that border on Ponzi schemes and that are underscored in this paper.
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