- 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.
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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,
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of the rational reminder podcast,
wherever you get your podcast.
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