The Unsolved Mystery of the Medallion Fund’s Success

(Bloomberg Businessweek) -- Most people on Wall Street have a tough time explaining the Medallion Fund, managed by the hedge fund company Renaissance Technologies. The most common answer is to just shrug and call it a money printing press. Currently open only to RenTech’s employees and a few other people connected to the firm, it’s generated average annual returns of close to 70% before fees since 1988 without ever suffering a yearly loss. After fees, it’s had one down year.. The Man Who Solved the Markets, a new book by Gregory Zuckerman, tells the story of Renaissance and its colorful founder Jim Simons, who worked as a mathematician and Cold War code breaker before trying his hand at the markets. Much of what Simon and his team—which includes dozens of Ph.D.s—actually do remains a secret hidden within its computerized trading system. (Renaissance declined to comment.) But a close look at return data from 1988 to 2010 answers some interesting questions and raises others..The data suggest that Medallion went through a big change at the turn of this century. From 1990 to 2000, the fund notches impressive gains, but like all hedge funds it loses money, too: It had 24 down months out of 120. In the following decade—which includes the tech bubble, the 2007 “quant quake” that rocked many hedge funds, the 2008 financial crisis, and the Flash Crash of 2010—Medallion loses money in only three months. Each of those monthly losses is less than 1%..This aligns with Zuckerman’s story of a breakthrough by ex-IBM researchers Robert Mercer and Peter Brown, who developed a highly profitable “statistical arbitrage” system for equities that complemented Medallion’s models for trading futures. Statistical arbitrage aims to capture small price discrepancies between two related securities while remaining hedged against overall market moves. The classic example is the spread between GM and Ford; the two ought to move roughly in step most of the time. But sometimes they’ll deviate because of some quirky bit of news or supply-and-demand pressures in one of the stocks, and it’s possible to construct a bet that will make money when the difference closes. Do it right and you can make money, even if auto stocks or the entire S&P 500 is falling. Modern statistical arbitrage systems are far more complex, often incorporating thousands of trades per day and using a wide array of data to predict prices..The returns of most investment managers are related to the markets they play in or some well-established “factor” that tends to predict performance. For example, there’s the value factor, which is the tendency of stocks that are cheap, relative to a company’s earnings or assets, to do better. When you crunch the numbers, even the performance of an investment master such as Warren Buffett can be at least partially explained by factors. A study by researchers at AQR Capital Management argues that Buffett’s returns are drawn from a mix of the factors favoring value, low volatility, and high-quality earnings..Medallion’s returns don’t seem to correlate with known factors—not small caps, not volatility, not momentum, nor any of the other usual suspects. Even more confounding is that the proliferation of other quantitative hedge funds in recent years hasn’t caused Medallion’s performance to deteriorate. Usually, when one quantitative investor finds a profitable trade, rivals sniff it out, too, and all the competition eventually kills the opportunity. So far, Renaissance seems still seems to be staying one step ahead of competitors or finding unique strategies..It’s not only casual observers who can’t figure out what makes Medallion tick: Even its closest competitors are in the dark. “I have so many questions about Medallion,” says Jon McAuliffe, co-founder of Voleon Capital, a top-tier quantitative hedge fund based in Berkeley, Calif. The most likely explanation may be a bit banal: that Renaissance does everything from cleaning up its data to trade execution just a bit better than everyone else. Summed up over millions of trades, these little advantages can equal big profits, especially when amplified with leverage, the borrowed money that helps fuel hedge funds’ returns. After deducting enormous expenses—5% of assets, plus up to 44% of profits—the fund still has an average annual return of 39% over its lifetime, according to Zuckerman..Great investment track records very often end in tears. Since it’s hard to see what Medallion does, it’s difficult to say what might trip it up. Zuckerman recounts—and Bloomberg Markets has reported—at least one close call. In 2007, the trading strategies of many quantitative funds suddenly started losing money fast. At one point, according to Bloomberg Markets, the fund was down almost $1 billion, a fifth of its value at the time. Ultimately, Renaissance stuck to its strategy, and the fund rebounded..If Medallion stumbles, it will it most likely be from competing firms finally catching up. Simons’s philanthropy, along with former co-Chief Executive Officer Robert Mercer’s, political activities, have brought the firm increased attention in recent years. The Man Who Solved the Markets will no doubt do the same for its strategies. Simons’s biggest challenge for the next decade will be keeping his secrets secret. —With Katherine Burton Freelance contributor Dewey is a portfolio manager at Royal Bridge Capital, a New York-based hedge fund. Moallemi is an associate professor at the Graduate School of Business at Columbia University..To contact the editor responsible for this story: Pat Regnier at pregnier3@bloomberg.net.©2019 Bloomberg L.P.

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The Unsolved Mystery of the Medallion Fund’s Success

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