- The Renaissance
Technologies Medallion Fund has reportedly returned 66% per
year on average before fees, for the period spanning 1988
to 2018, that is correct. 66% per year on average. Long-term consistent performance like this raises a lot of questions. Is the market really efficient? Do index funds still make sense? Or should you be trying to replicate the trading success of the medallion fund? To try to answer these questions we need to start with Jim Simons. I'm Ben Felix, Portfolio
Manager at PWL Capital. In this episode of common sense investing, I'm going to tell you to
the extent that I can, how Jim Simons solved the market and what his success means for you. (dramatic music) Much of the information about Jim Simons and the medallion fund
story in this video, comes from Greg Zuckerman's 2019 book, "the man who solved the market." which I highly recommend. If Jim Simons had never been
famous as a hedge fund manager, he still would have been and is famous as a code-breaker and a mathematician. Simons graduated from MIT with a bachelor of science and mathematics
at the age of 20. Completed his doctoral studies at MIT, and taught briefly at
both MIT and Harvard. He went on to work as a
code-breaker for the Institute for defense analysis, where
similar to his academic career he was able to make
meaningful breakthroughs. Simon's contributions to
mathematics cannot be understated. He was awarded the American
Mathematical Society's Oswald Veblen Prize in Geometry at
the age of 37 for his work. Including the chern-Simon's theory, which now has tens of thousands of citations in academic papers. Simon's also spent time chairing the math department at SUNY Stony Brook, building it into one of the best math departments in the world. The time that Simon spent working with world-class
cryptologists and building up a mathematics department, did more than build his hard skills. Through his experiences, Simons became uniquely qualified to recruit, manage, and work with the smartest
people on the planet. Throughout his time as a
cryptologist and an academic, Simons maintained an interest in financial markets and trading. He doubled a bit, and even
wrote a paper on the topic. But it wasn't until the age of 40 when Simons left academia
to pursue trading full time. At the onset, Simons recruited one of his old code-breaking
colleagues to join him. The colleague Leonard Baum, like Simons had been credited with
significant contributions to the field of mathematics. Baum had previously developed
the Baum-Welch Algorithm which can be used to find the unknown parameters
of a hidden Markov Model. This is highly relevant to trading because financial markets can be described as chains of hidden Markov Models. Speech recognition patterns can be described in the same way. Initially Baum and Simons
developed some models, but also relied on intuition to trade. They had some success, but
also some losses early on. Simons continued to attract some of the world's smartest
mathematicians to his operation. But it wasn't until 1988,
when his firm by then called Renaissance Technologies
launched the medallion fund. Other than attracting some of the smartest mathematicians in the world, Renaissance had done something else that few other firms
were doing at the time. They had created and cleaned massive sets of historical data to feed their models. Keep in mind that collecting data at that point in time, it meant recording the data stored in written records, to build out data sets that
could be fed into a computer. They were the first quant investors. Between their brilliant mathematicians and their data advantage,
medallion was able to build algorithms to identify patterns. Unlike traditional
investing, they did not care why these patterns existed. They placed frequent short
term trades augmented by lots of leverage to try and profit from what their models
deemed to be irregularities. Their models were so
successful at generating winning trades, that they
eliminated any human intervention. Allowing trades that would make
no sense at all to a human. They continued to tweak
and develop this system, adding more brilliant
mathematicians to do so. A big breakthrough came in the early 1990s when Renaissance was able to attract two key people from IBM's
speech recognition group. Remember speech recognition
and financial markets, are similarly described as
chains of hidden Markov Models. The medallion fund had been doing well, but Robert Mercer and Peter Brown were the beginning of what has become the greatest investing
track record in history. Mercer and Brown were able to develop a strategy to trade stocks, which Medallion had
previously struggled with. Most of their success had
come from trading in futures. Robert Mercer explained that their trades only won 50.75% of the time. But that's all it takes when the fund is making millions of trades and employing leverage. When Mercer and Brown
conquered stocks in 1995, the medallion fund took off. As a story, the success of the medallion fund is fascinating. The data seemed to suggest that Simons and his team have been able to uncover profitable patterns consistently, which should not be possible
in an efficient market. I can't tell you exactly
how they have done this. Not many people can. The employees are sworn to
legally binding secrecy. Bradford Cornell, a well-known financial economist at
UCLA, wrote a paper in 2019 titled "Medallion Fund the
ultimate counter example" in an attempt to figure it out. He explains a $100 invested in medallion in 1988 would be worth
$398.7 million in 2018. And medallion never had a
negative return over that period. The fund maintained negative
loading to no one risk factors, meaning that its success
has not been driven by known risk premia. Cornell explains, "In 40 plus
years of reading hundreds of papers on investment
anomalies, including some that benefited from data snooping
and ex-post selection bias, I have never seen any
performance approaching that reported by Medallion" Cornell even built a market timing model with perfect foresight,
investing in stocks when their subsequent
returns beat T-bills, and buying T-bills when they did not. Using monthly returns, this
perfect market timing model grew $100 into $331,288
from 1988 through 2018. Still only amassing less than 10% of what a Medallion investor would have earned over
the same time period. One important thing to note, is that our hypothetical Medallion investor, is as rare as medallion's
performance itself. The fund has been closed to
outside investors since 2003. So unless you were an
employee of the fund, you would not have been able to partake in most of the gains. The fund also distributes
its profits each year, capping the fund at $10 billion. This is to avoid one of the big issues that successful active
managers can always run into. When a successful fund grows, it sows the seeds of its own destruction by having more capital than
its strategies can handle. Alright, let's think about what this means for you, the investor. The success of medallion,
is without question a challenge to market efficiency. But remember, market
efficiency is a model. It is not reality. Another way to think about this, is that real life markets
cannot be perfectly efficient. This does not mean that
you can beat the market. Let's take a moment to think this through. Anytime that you make an active trade, you need to ask yourself
who is on the other side? What do they know that you don't? In this specific and unique
case of the medallion fund, they may have truly had better information due to better data and
better data interpretation using sophisticated models
developed by some of the world's smartest people. Even if they have figured out a persistent long-term advantage, nobody other than their
employees can access it. There is a finite amount of these types of trades to go around. Medallion is arbitraging away what might be the last scraps
of market inefficiency, and they're keeping the
profits for doing so. None of this makes Renaissance invincible. There are other quantum investors trying to crack the same code, competing with medallion to
mop up price irregularities. We always have to remember
the paradox of skill. If two equally skilled investors
are competing for alpha, the winner will be determined by luck. Medallion seems to have
had the edge on skill, but your guess on how
long that will persist especially in light of the funds or recent mass publicity,
is as good as mine. Unless I can get access
to the medallion fund, I'll stick with my index funds. And even if I could get access, betting on their persistence
would make me nervous. Thanks for watching. I'm Ben Felix of PWL Capital, and this is common sense investing. If you enjoyed this video,
please share it with someone who you think could
benefit from the information. And don't forget, if you've run out of common sense investing videos to watch, you can tune into our weekly episodes of the rational reminder podcast, wherever you get your podcast. (dramatic music)
