Sweet Mama. This is the closest I have gotten to this secret sauce eof Ren Tech black swan risk and probability of a loss tricks
From someone who knew all the founders of Ren Tech:
I have known Jim Simons, Bob Mercer and Peter Brown since 1965, 1974, and 1979, respectively. Renaissance has also hired senior researchers who had formerly worked for me for years. None of these people has ever told me anything about Renaissance’s investment strategies. My observations below have been obtained entirely from publicly available records.
In particular, the core strategy is publicly known. It’s the details that are proprietary. There are millions of details, and they are essential to the performance. However, the question was about strategy, so that is what I will try to answer.
The core strategy is portfolio-level statistical arbitrage carried to the limit and executed extremely well. Basically, portfolios of long and short positions are created that hedge out market risk, sector risk and any other kind of risk that Renaissance can statistically predict. The extreme degree of hedging reduces that net rate of return but the volatility of the portfolio is reduced by an even greater factor. The standard deviation of the value of the portfolio at a future date is much lower than its expected value. Therefore, with a large number of trades the law of large numbers assures that the probability of a loss is very small. In such a situation, leverage multiplies both the expected return and the volatility by the same multiple, so even with a high leverage the probability of a loss remains very small.
The general properties of the strategy can be deduced from the statement of Renaissance for the Hearing of the Senate Permanent Subcommittee on Investigations, dated July 22, 2014. [
Renaissance collects “all publicly available data [they] can that [they] believe might bear on the movement of prices of tradable instruments–news stories, analysts’ reports, energy reports, crop reports, weather reports, regulatory findings, accounting data, and, of course, quotes and trades from markets around the world.”
Their models “use this data to make predictions about future price changes.”
The hearing was specifically about the Medallion fund, about which the statement says “The model developed by Renaissance for Medallion makes predictions that are profitable only slightly more often than not.”
With these properties, there were two reasons that Renaissance would like to have a call option on the portfolio that it has designed: leverage and protection against Black Swan events.
Leverage is needed because, unleveraged, the rate of return of the portfolio is low. However, because the volatility is much less than the expected return there is no limit to how high the leverage could be without increasing the probability of a loss, at least according to the models. Through years of use and refinement, Renaissance knows that its models are very reliable. However, they also know that there is always the risk of something happening that is not covered by the models, in particular something that is outside prior experience, which is called a “Black Swan” event.
Thus, a call option is ideal: it can provide high leverage and can provide protection both against the very low probability of a loss greater than the option premium and also against the unknown probability of a possibly catastrophic loss due to a Black Swan event.
We know all this because these are the business reasons for Renaissance accepting Deutsche Bank’s proposal of barrier options. Basically, Deutsche Bank, and later Barclays, sold the equivalent of a call option to Renaissance on the reference portfolio that Renaissance designed.
Of course, writing an uncovered call on the Renaissance portfolio would be equivalent to betting against Renaissance at high leverage, which would seem to be a foolish thing to do. The banks covered these options by buying all of the securities in the portfolio. Thus the bank’s position was equivalent to a covered call. In other words, the banks’ profits and risks were essentially equivalent to writing a put option, which is a bullish position. Because the volatility was very low the probability of a loss for the bank was low and the probability of a loss greater than the option premium was even lower.
Except for the Black Swan risk. The probability of a Black Swan risk is unknown. Part of the premium paid by Renaissance and earned by the banks was equivalent to insurance against Black Swan risk. I don’t know if the amounts of the premiums were publicly disclosed.
There were many more details in the statements and the testimony at the hearings. However, discussion of further details would detract from the important points that I have made above. In particular, the hearings themselves were about tax issues not about investment strategies. Renaissance explicitly asserted, under oath, that its “models do not factor in tax rates when making trading decisions.” Therefore, tax issues, although they might be very important, are not part of the “investment strategy” at least as reflected in the models, so they are outside the scope of this particular discussion.
[Edit (added in answer to a comment): The reference portfolio was highly dynamic. There were thousands of trades per day. To accomplish this, the banks gave RenTech’s computers direct access to execute trades through the banks’ trading desks.
This arrangement was part of what created controversy about what should be the proper tax treatment for this particular case. However, I am not a tax lawyer and will not try to analyze those issues. However, if you want to hear more details on the automatic execution of the trades, and questions about how much human interaction was present, that is all discussed in the live testimony before the subcommittee: [
I have copied this in case the Quora link disappears which is from
Notes from Senate hearings include:
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