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Mpi TheLawOfLargeNumbers2007Q3

Mpi TheLawOfLargeNumbers2007Q3

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 © 2007, Markov Processes International, LLC
MPI Quantitative Research Series
 
The Law of Large Numbers, one of the last great gifts of the Renaissance, was first described by Jacob Bernoulli as so simple that “even the stupidest man instinctively knows it is true
1
.” It thentook him over twenty years to derive a rigorous proof of his famous theorem. Some three hundred  years later, the same law under a new name “diversification” has found its proof in financialmarkets. Our analysis of the Renaissance Institutional Equities Fund shows that thousands of trades,based on fundamental signals generated by computer models, can average to a simple combinationof factors that mimic the performance of this large and well-known hedge fund.
Background
In the beginning of August 2007, quantitativelymanaged funds had been making headlines for higher-than-anticipated losses in increasingly volatile markets.One of these high-profile funds receiving muchattention is also one of the largest: the $26BRenaissance Institutional Equities Fund (RIEF),managed by Renaissance Technologies of EastSetauket, New York. Renaissance Technologies, startedin early 1980’s by former mathematics professor JamesSimons and employing a team that includes overseventy PhDs, is also home to the famous Medallionfund, which has an exemplary track record dating back to the 1980’s. The Medallion fund’s 5% managementfee and 44% performance fee are head and shouldersabove the industry’s standard 2/20. Unlike Medallion,RIEF has lower fees, higher capacity of $100B andtargets institutional investors. 
1
 On August 10,
 Reuters
reported that Simons had sent aletter to the funds’ investors stating its July loss to bebetween -4.0% and -4.5%, and August-to-date losses“in the order of 7%.”[1] The refrain from most articlesappears to be that either the models broke or, perhapsmore likely, that different models in many other quant
1
Source: Wikipedia http://en.wikipedia.org
shops appear to have been advocating similar positions.The need to liquidate these positions while waiting fortheir models to recover from the markets’ paradigmshift could have caused increased systematic exposureat the worst possible time. However, this may only be apart of the story.Using Dynamic Style Analysis [3], [4] (referred to as“DSA” from this point forward), MPI’s proprietaryreturns-based factor model, and the fund’s historicalperformance data (NAV returns), we performed ourown quantitative due diligence analysis on the fund inan attempt to see if some of the losses could (or should)have been anticipated.Please note, at no time in this analysis are we claimingto know or insinuate what the actual strategy, positionsor holdings of this fund were; nor are we commentingon the quality or merits of Renaissance’s strategy orthat of any other manager. Instead, we are seeking todemonstrate how advanced returns-based analysis canbe used to better understand fund behavior, anticipateperformance, identify risks and, possibly, replicate fundperformance in certain cases.
The Law of Large Numbers:An Analysis of the Renaissance Fund
A case study in hedge fund replication and riskmanagement
September 2007Michael MarkovCo-Founder & CEOMarkov Processes International908.608.1558mmarkov@markovprocesses.com
 
 
 © 2007, Markov Processes International, LLC Page 2
RIEF Strategy Close Up
Although few details are known about the fund’s strategyoutside of its 200 employees, in the series of recentinterviews [6-8], Simons has shed light on the way theInstitutional Fund is managed. On the one hand, RIEF istaking advantage of proven computer models, tradingsignals and risk management techniques of theRenaissance Medallion fund, which has an exceptionaltrack record and is closed to outside investors. On theother hand, unlike Medallion which is investing acrossmultiple asset classes, RIEF is investing primarily in3,000 to 4,000 U.S. public equities and making long-termbets with a significant holding period, as compared with“rapid-fire” trading of the Medallion. The fund is makinglong and short bets maintaining a moderate leveragelevel. Overall, risk of the RIEF is described as slightlylower than that of the S&P 500 Index, although the fundis not intended to track the index. In other words, thefund is presented as having low volatility and lower risk than the market and represents a long-short strategy witha relatively low turnover.It is worth noting that over the past two years thestrategy accumulated in excess of $26B in assets. Thefund launched on August 1, 2005 with $600M and thedemand was so high that it put a cap of $2B on monthlyinflows. In November 2006, it had $14B undermanagement and added another $12B in the followingyear–a record number for a hedge fund.Historical performance and risk of the stated strategyare easily assessed using the fund’s historical return
2
 and those of the S&P 500, since August 2005 (thefund’s inception). Annualized returns since the fund’sinception through June were 15.35% for their B series(net of fees) and 19.03%
 
gross of fees, compared to12.95% for the S&P 500 (Figure 1).
Figure 1
Return
Annualized standard deviation for the same period wasmarginally lower gross of fees, at 6.52%, compared to6.74% for the S&P 500 (Figure 2). The remainder of the analysis is conducted using the gross of fees series.
Figure 2
Risk
Created with MPI Stylus™
Risk (Annual StdDev)
As of June 200701234567
   T  o   t  a   l   A  n  n  u  a   l   i  z  e   d   S   t   d   D  e  v ,   %
2005 - 20076.525.756.74Renaissance Inst'l Equities Fund LLCRenaissance Inst'l Equities Fund LLC, Ser BS&P 500 Index
 
A typical due diligence analysis of such a fund wouldinclude calculations of its MPT statistics (alpha, beta,Sharpe Ratio, etc.) along with numerous ratios andgain/loss statistics. The issue with such statistics is thatthey often have little predictive power, can bemisleading and result in a false sense of security–thelast thing a hedge fund investor needs in a time of crisis.For instance, one may decide to use the fund’s beta toestimate its losses in July. Thus, beta vs. the S&P 500index computed through June is 0.43, and is well in linewith the fund’s strategy of maintaining a low marketrisk. Given that the S&P return for July was -3.1%, wewould have estimated July’s return for the fund to bearound -1.3%. Since the fund’s return was actually lessthan -4%, it demonstrates once again that low beta of hedge funds has to be taken with a grain of salt. It mustbe said that low beta values of hedge funds are similarto those of balanced mutual funds such as VanguardWellington
3
, thus implying lower systematic risk. Whatis usually neglected is that - compared to mutual funds-corresponding R-squared values are very low for hedgefunds (e.g., 20% for RIEF) placing little trust on thebeta number itself.
2
 
Renaissance RIEF returns were obtained from a hedge funddata vendor
 3
Wellington’s beta vs. S&P 500 Index is 0.6 with theR
2
=85%
Created with MPI Stylus™
Total Return
As of June 200702468101214161820
   T  o   t  a   l   A  n  n  u  a   l   i  z  e   d   R  e   t  u  r  n ,   %
Aug-05 - Jun-0719.0315.3512.95Renaissance Inst'l Equities Fund LLCRenaissance Inst'l Equities Fund LLC, Ser BS&P 500 Index
 
 
 © 2007, Markov Processes International, LLC Page 3
Based on our computations, RIEF Sharpe Ratio throughJune 2007 looked attractive at 1.99 and 1.70 for grossand Shares B net of fees, respectively (Figure 3),compared to that of 1.14 for the S&P 500 Index.
Figure 3
Sharpe Ratio
Created with MPI Stylus™
Sharpe Ratio
As of June 20070.00.51.01.52.0
   S   h  a  r  p  e   R  a   t   i  o
08/05 - 06/071.991.701.14Renaissance Inst'l Equities Fund LLCRenaissance Inst'l Equities Fund LLC, Ser BS&P 500 Index
 
It is worth noting that despite its frequent use in hedgefund promotional literature,
ex post 
Sharpe Ratioprovides very little guidance regarding future fundefficiency, especially for such skewed and non-normaldistribution patterns as that of the Renaissance Fund,for which the return distribution histogram is shown inFigure 4.
Figure 4
Distribution of Returns
Reverse-Engineering the Renaissance
So what analysis does work for such a hedge fund whenonly a monthly performance track record is available toinvestors? One of the most effective methods isReturns-Based Style Analysis (or
 RBSA
), a regressionmethodology first proposed by Prof. William Sharpe inthe late 1980’s to identify a credible combination of systematic market factors that explain or best mimic thefund’s performance variability. Although such anapproach may not always provide the level of insightone would like, especially in cases where funds areinvolved in statistical arbitrage and/or employ illiquidsecurities, Renaissance is a particularly good examplebecause (1) the fund was well diversified, investing inthousands of securities and, more importantly, (2) thestrategy was somewhat “directional” with a holdingperiod for stocks of over a year. These factors increasethe likelihood of having a credible analysis of Renaissance returns.To better understand what factors are influencing thefund’s returns, we use MPI’s proprietary returns-based“DSA” technology to perform a dynamic regression of 24 monthly fund returns through July 2007 usingcorresponding monthly returns on generic marketindices as explanatory variables. For this analysis weused six Russell Style indices and the MSCI EAFEIndex, which was used to sense the fund’s exposure toforeign stocks. Since the fund is involved in sellingstocks short, we didn’t impose any non-negativityconstraints (which are typically used in the analysis of long-only products such as mutual funds). We let themodel select the optimal smoothness of exposure pathsas well as the limited, most predictive set of factors outof the seven selected. The results shown in Figure 5depict the market factor weights that best simulate thefund’s behavior over time.
Figure 5
Historical Factor Exposures
Created with MPI Stylus™
Style Analysis
-100-80-60-40-20020406080100120140160180200
   W  e   i  g   h   t ,   %
08/0512/0503/0606/0609/0612/0603/0707/07SmGrowthSmValueMid GrowthMid ValueTop GrowthTop ValueMSCI EAFE ND
 
Created with MPI Stylus™
Distribution of Monthly Return
Aug 05 - Jun 07
02468101214
   F  r  e  q  u  e  n  c  y ,   %
-2.00-1.50-1.00-0.500.000.501.001.502.002.503.003.504.004.505.005.506.00Total Return, %
Renaissance Inst'l Equities Fund LLC

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