By Pam Martens: June 1, 2021 ~
“…no adequate rational market explanation for this performance.”
Quietly, at the start of a three-day weekend, Bloomberg News published this titillating news item about the hedge fund Renaissance Technologies, known as RenTech or RenTec on Wall Street:
“Credit Suisse Group is temporarily barring clients from withdrawing all their cash from a fund that invests with Renaissance Technologies…The fund lost about 32% last year, in line with the decline in the Renaissance Institutional Diversified Alpha Fund International fund that it invests into, the people said. Renaissance, regarded as one of the most successful quant investing firms in the world, was rocked by billions of dollars in redemptions earlier this year after unprecedented losses in 2020.”
Put the above paragraph together with the paragraph below from a Bloomberg report on February 8 and you can see why tongues are wagging across Wall Street:
“RIEF [ Renaissance Institutional Equities Fund], lost 19% in 2020, the letters show. That fund got the biggest chunk of the redemptions. The Institutional Diversified Alpha fund dropped 32% and the Institutional Diversified Global Equities fund fell 31%. Medallion gained 76%, according to Institutional Investor.”
Here’s the thing: the Renaissance Medallion fund is only available to current and former partners and employees of Renaissance Technologies. To put it another way, insiders are getting super rich while outside investors lose their shirts.
That brought to mind something I had observed working at Sandy Weill’s name-laundering operation known variously over the years as Shearson/American Express, Shearson Lehman, Shearson Smith Barney, Salomon Smith Barney, then just Smith Barney. It’s now part of Morgan Stanley.
I would be working in my office after hours and observe a young, unlicensed clerical worker typing up trade tickets for her broker boss, long after the markets had closed. In those days, before trades were entered on the computer, paper trade tickets were usually written out quickly by hand by the licensed broker, then time-stamped, and quickly submitted to the wire operator to make certain that the broker was complying with stock exchange rules.
I asked the young woman what she was doing. It turned out that this is how her boss handled allocations of Initial Public Offerings (IPOs). He allocated the trades to clients after the market had closed, knowing at that point if the stock had popped or dropped on its first day of trading. And his supervisor let him get away with it.
Am I suggesting that Renaissance is giving its best trades to its own insiders? Absolutely not. But I am suggesting that if someone were nefariously inclined, it wouldn’t be hard to engineer performance results.
The Medallion fund has been restricted to just insiders since the end of 2005. Other folks are also getting curious about its lopsided results. Cornell Capital Group studied its performance and wrote the following eyebrow-raising analysis:
“The performance of Renaissance Technologies’ Medallion fund provides the ultimate counterexample to the hypothesis of market efficiency. Over the period from the start of trading in 1988 to 2018, $100 invested in Medallion would have grown to $398.7 million, representing a compound return of 63.3%. Returns of this magnitude over such an extended period far outstrip anything reported in the academic literature. Furthermore, during the entire 31-year period, Medallion never had a negative return despite the dot.com crash and the financial crisis. Despite this remarkable performance, the fund’s market beta and factor loadings were all negative, so that Medallion’s performance cannot be interpreted as a premium for risk bearing. To date, there is no adequate rational market explanation for this performance.”
The Sovereign Wealth Fund Institute is also curious about these disparate returns. It wrote the following on February 7: “This serious type of discrepancy between internally managed funds and capital run for outside investors is truly unprecedented. Will the U.S. Securities and Exchange Commission (SEC) investigate?”
Renaissance Technologies previously came under scrutiny by the U.S. Senate’s Permanent Subcommittee on Investigations in 2014. The Subcommittee concluded that it had avoided paying $6.8 billion (yes, billion) in taxes to the IRS as a result of a trading scheme with mega banks on Wall Street.
In a hearing held by the Subcommittee on July 22, 2014, Steven M. Rosenthal, a Senior Fellow at the Urban-Brookings Tax Policy Center in Washington, D.C., explained the scheme as follows:
“I have been asked to evaluate the character of the gains of the Renaissance hedge funds based on my review of materials provided by the Subcommittee staff. The Renaissance hedge funds traded often, more than 100,000 trades a day, more than 30 million trades a year, and they traded quickly, turning over their portfolio almost completely every 3 months. Because the hedge funds adopted a short-term trading strategy, we would expect their gains to be short term. But the hedge funds, with the help of Barclays and Deutsche Bank, wrapped derivatives around their trading strategy in order to transform their short- term trading profits into long-term capital gains. This tax alchemy purported to reduce the tax rate on the gains from 35 percent to 15 percent and reduced taxes paid to the Treasury by approximately $6.8 billion. I believe the hedge funds stretched the derivatives beyond recognition for tax purposes and mischaracterized their profits as long-term gains.”
According to documents released as part of the Senate investigation, the trading structure worked like this:
The hedge fund would make a deposit of cash into an account at the respective bank. The account was not in the hedge fund’s name but in the bank’s name. The bank would then deposit into the same account $9 for every one dollar the hedge fund deposited. At times, the leverage could reach as high as 20 to 1.
The hedge fund controlled the trading in the account and generated tens of thousands of trades a day using their own high frequency trading program and algorithms. Many of the trades were held for mere minutes. The bank charged the hedge fund fees for the trade executions and interest on the money loaned.
There was a written side agreement called a “basket option.” The side agreement specified that the hedge fund would collect all the profits made in the account in the bank’s name after a year or longer. This, according to the scheme, allowed the hedge fund to characterize millions of trades which were held for less than a year, many for just minutes, as long-term capital gains (which by law require a holding period of more than a year).
At the time of the Senate investigation, long term capital gains were taxed at less than half the top rate on short term gains. Today, the top tax rate on long-term capital gains is 20 percent while the top rate on short-term capital gains, which are taxed as ordinary income, is 37 percent.
All of the stock trades were executed in the name of the bank and held in the bank’s proprietary trading account. Profits or losses on the trades remained in the account until the so-called “basket option” was exercised. The hedge fund had discretion on when it could exercise the option.
According to the Subcommittee’s investigation, losses in the account were handled as follows:
“The banks claimed that the hedge funds did not bear 100% of the risk of loss, because the banks provided so-called ‘gap’ protection in the event of a catastrophic market failure. That risk was so small, however, that despite, for example, hundreds of millions of trades that took place in the more than 60 basket options held by RenTec over a decade, including during the worst financial crisis in a generation, neither bank was ever required to satisfy a loss due to a market failure.
“To further minimize the gap risk, the option contract contained several provisions designed to limit trading losses in the account to the 10% premium provided by the hedge fund. The key provision accomplished that objective by specifying a loss threshold – sometimes called a ‘barrier’ or ‘knockout’ amount – which if reached would cause the option to cease to exist, or ‘knockout,’ and trigger the ability of the bank to liquidate the account assets.”
The IRS released a memo in 2015 indicating that the basket option was an improper maneuver to convert short term capital gains into long term gains.
Renaissance Technologies hired aggressive lawyers to fight the matter out in tax court for years. To date, there has been no media report to suggest that the hedge fund has settled the case with the IRS or that the Justice Department has opened an investigation.
Senator Ron Wyden, Chair of the Senate Finance Committee, and Senator Sheldon Whitehouse, Chair of the Subcommittee on Federal Courts, Oversight, Agency Action and Federal Rights sent a letter to U.S. Attorney General Merrick Garland and IRS Commissioner Charles Rettig on April 28. The letter reveals that the two Senators are probing the potential for political interference from Trump’s Justice Department and/or White House in the Renaissance matter as well as one involving Caterpillar. The Senators write as follows regarding Renaissance:
“According to public reports, since 2017 the IRS has reportedly sought to collect approximately $7 billion in back taxes from Renaissance for its use of basket options contracts, a type of transaction the IRS has long considered an abusive tax avoidance technique. Renaissance has contested the tax bill and is reportedly exploring the possibility of a settlement to reduce its tax liability…
“Among the individuals with a direct financial interest in the matter is former Renaissance co-chief executive officer Robert Mercer. In 2016, Mr. Mercer gave $22.5 million in disclosed donations to Republican candidates and to political-action committees, including $15.5 million to a pro-Trump Super PAC called Make America Number 1. The Make America Number 1 Super PAC also employed Stephen Bannon and Kellyanne Conway, who both went on to take senior positions in President Trump’s White House.”
The letter goes on to ask for a litany of answers and documents, including the following:
“Please provide all documents and communications since January 20, 2017 identifying any contact between any employee of the White House or any unofficial adviser to the President with any employees of the DOJ and IRS related to ongoing investigations, enforcement actions, and regulatory decisions related to tax matters involving specific parties, including, but not limited to, Caterpillar and Renaissance.”
Wyden and Whitehouse are not men to be taken lightly. The documents were due by May 18. We’re expecting to hear about new Senate hearings into these matters.