Wednesday, July 11, 2007

Hedge funds or market makers?

To what extent are Citadel, DE Shaw and Renaissance really just big market makers? The essay excerpted below is by Harry Kat, a finance professor and former trader who was profiled in the New Yorker recently.

First, from the New Yorker piece:

It is notoriously difficult to distinguish between genuine investment skill and random variation. But firms like Renaissance Technologies, Citadel Investment Group, and D. E. Shaw appear to generate consistently high returns and low volatility. Shaw’s main equity fund has posted average annual returns, after fees, of twenty-one per cent since 1989; Renaissance has reportedly produced even higher returns. (Most of the top-performing hedge funds are closed to new investors.) Kat questioned whether such firms, which trade in huge volumes on a daily basis, ought to be categorized as hedge funds at all. “Basically, they are the largest market-making firms in the world, but they call themselves hedge funds because it sells better,” Kat said. “The average horizon on a trade for these guys is something like five seconds. They earn the spread. It’s very smart, but their skill is in technology. It’s in sucking up tick-by-tick data, processing all those data, and converting them into second-by-second positions in thousands of spreads worldwide. It’s just algorithmic market-making.”

Next, the essay from Kat's academic web site. I suspect Kat exaggerates, but he does make an interesting point. Could a market maker really deliver such huge alpha? Only if it knows exactly where and when to take a position!

Of Market Makers and Hedge Funds

David and Ken both work for a large market making firm and both have the same dream: to start their own company. One day, David decides to quit his job and start a traditional market-making company. He puts in $10m of his own money and finds 9 others that are willing to do the same. The result: a company with $100m in equity, divided equally over 10 shareholders, meaning that each shareholder will share equally in the companyís operating costs and P&L. David will manage the company and will receive an annual salary of $1m for doing so.

Ken decides to quit as well. He is going to do things differently though. Instead of packaging his market-making activities in the traditional corporate form, he is going to start a hedge fund. Like David, he also puts in $10m of his own money. Like David, he also finds 9 others willing to do the same. They are not called shareholders, however. They are investors in a hedge fund with a net asset value of $100m. Just like David, Ken has a double function. Apart from being one of the 10 investors in the fund, he will also be the fundís manager. As manager, he is entitled to 20% of the profit (over a 5% hurdle rate); the average incentive fee in the hedge fund industry.

At first sight, it looks like David and Ken have accomplished the same thing. Both have a market-making operation with $100m in capital and 9 others to share the benefits with. There is, however, one big difference. Suppose David and Ken both made a net $100m. In Davidís company this would be shared equally between the shareholders, meaning that, including his salary, David received $11m. In Ken's hedge fund things are different, however. As the manager of the fund, he takes 20% of the profit, which, taking into account the $5m hurdle, would leave $81m to be divided among the 10 investors. Since he is also one of those 10 investors, however, this means that Ken would pocket a whopping $27.1m in total. Now suppose that both David and Ken lost $100m. In that case David would lose $9m, but Ken would still only lose $10m since as the fundís manager Ken gets 20% of the profit, but he does not participate in any losses.

So if you wanted to be a market maker, how would you set yourself up? Of course, we are not the first to think of this. Some of the largest market maker firms in the world disguise themselves as hedge funds these days. Their activities are typically classified under fancy hedge fund names such as ëstatistical arbitrageí or ëmanaged futuresí, but basically these funds are market makers. This includes some of the most admired names in the hedge fund business such as D.E. Shaw, Renaissance, Citadel, and AHL, all of which are, not surprisingly, notorious for the sheer size of their daily trading volumes and their fairly consistent alpha.

The above observation leads to a number of fascinating questions. The most interesting of these is of course how much of the profits of these market-making hedge funds stems from old-fashioned market making and how much is due to truly special insights and skill? Is the bulk of what these funds do very similar to what traditional market-making firms do, or are they responsible for major innovations and/or have they embedded major empirical discoveries in their market making? They tend to employ lots of PhDs and make a lot of fuzz about only hiring the best, etc. However, how much of that is window-dressing and how much is really adding value?

Another question is whether market-making hedge funds get treated differently than traditional market makers when they go out to borrow money or securities. Given prime brokersí eagerness to service hedge funds these days, one might argue that in this respect market-making hedge funds are again better off then traditional market makers.

So what is the conclusion? First of all, given the returns posted by the funds mentioned, it appears that high volume multi-market market making is a very good business to be in. Second, it looks like there could be a trade-off going on. Market-making hedge funds take a bigger slice of the pie, but the pie might be significantly bigger as well. Obviously, all of this could do with quite a bit more research. See if I can put a PhD on it.



jck said...

Long ago, a physicist gave a course on market-making.He was surprised that his students "became restive in the course because we did not seem to be discussing items of practical interest on how to make a buck...They wanted to know how to predict.Apparently the message that market-making could be quite profitable didn't get accross or else 50% annual return isn' t good enoough."

steve said...

Hey, I know that quote!

The course was taught at Berkeley and the physicist was on leave from the Naval Research lab.

Osborne discusses market making quite a bit. He also (empirically) discovered log-normality of stock prices long before any economist!

Highly recommended, although the lecture note format might be off-putting to some.

jck said...

Right on.
Amazingly nothing better has been written on market-making since then...

Anonymous said...

You are missing the biggest reason these firms want to be known as a hedge fund and not a market maker. The tax treatment for someone classified as a "securities or derivatives dealer" is substantially different from how a hedge fund investors and principals are taxed.

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