Monday, November 21, 2005

Beating The Market

The following article appeared this past weekend in the NY Times. More evidence that the "random walk" theory of not being able to beat the market in the long run is erroneous. In fact, based on Renaissance's track record and to a much lesser extent, the work we've been doing day-trading the past two years, the opposite seems to be true. You can beat the market, if you are of the mind to do so.

NYTimes: $100 Billion in the Hands of a Computer


PEOPLE ask me all the time: What's your secret?" James Simons said. We were sitting in an office in Manhattan that Mr. Simons uses when he's not at the Long Island offices of Renaissance Technologies, the money management firm he founded in 1982. He was wearing an elegant shirt and tie, and loafers with no socks. He took a drag from a cigarette, the second of three he would smoke in the course of a long interview.

I had indeed come to ask him what his secret was. In the hedge fund world, that's what everybody wants to know.

Mr. Simons, 67, who rarely talks to journalists, is hardly a household name like Warren E. Buffett. But Mr. Simons, who got into the hedge fund business after abandoning a stellar career in mathematics, has a track record that is jaw-dropping. This summer, word leaked out that he was starting a new fund - people took to calling it the "$100 billion fund" because its marketing materials say that it could conceivably grow to that enormous size. Not surprisingly, that has caused Wall Street types to be even more curious about him.

Here are Mr. Simons's numbers: from 1990 to 2004, Renaissance's primary hedge fund, called Medallion, has delivered annualized returns of 33.21 percent. (The Standard & Poor's 500-stock index has returned, on average, 10.98 percent during those same years.) Since the end of 2002, the fund, which has $5 billion under management, has disbursed $4.9 billion to its investors - with another $1.5 billion to be delivered at the end of this year.

And these returns are after Medallion's 5 percent management fee and 44 percent share of the profits - surely the highest hedge fund fees in the land. Medallion's returns, and its fees, have helped make Mr. Simons a very wealthy man, with a net worth that Forbes estimates at $2.7 billion.

When I showed Mr. Simons's returns to a hedge fund friend, he looked startled. "Nobody has numbers like those," he said. But here's the real eye-opener: no one outside the firm's 200 or so employees has a clue how he does it.

Medallion, you see, is a quantitative fund. In quant funds, trading activity is generated by complex computer models rather than human judgment. Most quants are secretive about the algorithms that drive their models; after all, that's their investing edge. But of the handful of big-time "black box" investors, as they're often called, Mr. Simons's box may well be the blackest.

HERE'S what we do know. Medallion's portfolio contains literally thousands of stocks and other financial instruments that it trades in rapid-fire fashion. The firm's scientists are constantly searching for repeatable patterns, and other signals, in the enormous amounts of data they compile. The computer models they devise tell them when to make trades based on those signals.

As Mr. Simons put it - and this is about as specific as he would get - "Certain price patterns are nonrandom and will lead to a predictive effect." He also told me that Medallion sticks with highly liquid securities that trade in public markets around the world. Why? "Because there is a lot of data on such instruments, and we're very statistically oriented," he said. He stays away from exotic derivatives.

Not even Mr. Simons's investors know much more than I've just described. "We trust Jim and we think he's smart," said one longtime Medallion investor. "So we stopped caring what the computer was doing." When this investor began describing Mr. Simons's investing approach, he admitted he was guessing.

Mr. Simons shrugged when I suggested to him that his firm's lack of "transparency," as they say in the business, was bound to make people nervous. Humans fail in the market all the time, but somehow we are willing to keep giving our money to human beings to manage because we understand investing based on human judgment. Or at least we think we do. But black box investing feels different. It feels scary somehow, precisely because it is not something most of us can understand.

"How any great investor does it isn't in the least obvious," Mr. Simons responded. "How we do it isn't any more mysterious than how a great fundamental investor does it. In some ways it is less mysterious because what we do can be programmed." Then he stopped, took another drag from his cigarette, and let out a small chuckle. "Well," he conceded, "it's less mysterious to us."

Mr. Simons wasn't always a quant. A former crypt analyst - a code breaker, that is - he did important work in mathematics that helped lay the foundation for string theory. When he began managing money in the 1970's, he did it the same way most investors did: he used his own judgment. "At first," he said, "I didn't think about investing in a scientific fashion. But I was trading currencies, and it gradually occurred to me that there might be some way to create models that would allow you to predict currency movements."

Although Mr. Simons and a partner made an absolute killing in the currency markets the old-fashioned way - they made huge bets that turned out to be right - he began surrounding himself with scientists who developed models for all sorts of tradeable securities. "By the end of the 1980's," he said, "I was a model man, and didn't want to do fundamental analysis." One advantage, he said, is that "models can lower your risk." Another, though, is that "it reduces the daily aggravation." With old-fashioned stock picking, he said: "One day you feel like a hero. The next day you feel like a goat. Either way, most of the time it's just luck."

Indeed, trading the way he does, making thousands of small trades aimed at capturing small price movements, doesn't generate the kind of "10 bagger" that investors love. But when done well, quant investing is less likely to have the kind of disaster that is always the danger when one bets big on a stock.

To those who point to Long-Term Capital Management as an example of the dangers of black box investing, Mr. Simons's defenders point out that his fund has far less leverage than Long-Term Capital, and that in any case, while Long-Term Capital had several Nobel laureates on board, human bets were what caused it to go awry.

Clifford Asness, another well-known quant hedge fund manager, said that while he knew no more about Mr. Simons's methods than anyone else, "It's hard to believe that there isn't a measure of safety in Jim's approach.

"Presumably, he's got a highly diversified portfolio, high turnover, and he's capturing small inefficiencies. It's hard to lose a ton of money doing that. It is always possible that someday his models might stop working. But that's different from 'blowing up.' "

"You know," Mr. Asness added, "human beings have a black box, too. It's called the brain."
As for the new "$100 billion fund," Mr. Simons was even more constrained than usual, thanks to regulatory restrictions that limit what he can say publicly while the fund is raising money. People are buzzing about it nonetheless, for it seems to be a major departure from Medallion. Medallion's investors were almost all wealthy individuals; the new fund, called the Renaissance Institutional Equities Fund, has a $20 million minimum investment and is aimed at institutions. It has a much lower fee structure. It will invest in - or sell short - only publicly traded equities. Instead of making rapid-fire trades, it will be much closer to a buy-and-hold portfolio. And so on.

In one critical way, though, it is similar to Medallion. As the marketing document, which I obtained from a person unconnected to Mr. Simons, put it: "The company's risk control, variance and covariance estimation, execution techniques, slippage models, and predictive signals are all derived from those employed by the managing member in trading the Medallion Funds."

In other words, Mr. Simons believes that computer models similar to those that have worked for Medallion will also work for a fund that can hold $100 billion worth of stocks over long periods of time. It is absolutely audacious.

What interested me most of all was: why? At an age when most men are contemplating retirement, with more money than he can count, why was Mr. Simons still at it? "I enjoy the challenge," he replied.

He then began describing a demonstration he saw recently of a new nuclear accelerator at the Brookhaven National Laboratory, where he is on the board. Two atoms hurtled toward each other, colliding with great force. "A huge number of particles are thrown out," he said, "and the job is to analyze everything that results from the collision."

"Watching the spray of particles on the screen made me think of the stock market," he continued. Every trade, even of a hundred shares of a company, affects every other trade. And every day there are thousands upon thousands of such trades, all of them affecting the rest of the market. His work, as he sees it, is to analyze that incredibly complex mosaic and try to figure out how it all fits together.

"The subject may not be the most important in the world," he concluded, "but the dynamics of the market are really interesting. It's a serious question."

I suddenly understood the motivation behind Mr. Simons's new fund. He's doing it because he wants to see if it can be done. Once a scientist, always a scientist.


Ronny said...

Allan,thanks for posting the interview.This is very impressive considering how large his fund is.
Have you purchased any I-buys in the last week? I got lucky with RUTH and FICC,not as much with SYMC.

A said...

Ron, the cool thing about Renaissance is not so much the amount of profits, but how they are doing it, trading, real trading, not this "swing trade" stuff which isn't much different from stale B&H approaches. You can assume that any I-Buy of significance is in my account, if only for a moment or two.


Anonymous said...


I enjoyed the article, but some of the terms you're using are unfamiliar to me. Can you help me with some of the jargin? What is random walk, swing trading vs. real trading, B&H (buy and hold?) amd I-buy. Thanks for your blog, it's become a part of my daily web scan!

A said...

Random Walk

The theory that stock prices are unpredictable and that its impossible to outperform the market without assuming additional risk.

Swing Trading

Trading stocks for 1-4 day price movements.

Buy & Hold

Passive investments characterized by very long term holding periods, measured in months and/or years.


"Insider-Buys," whereby an officer, director or other large shareholder of a company buys initial and/or additional shares of stock in the company, as reported by the Securities and Exchange Commission. The significance of I-buys, as espoused on this Blog and elsewhere, specifically on numerous commercial stock advisory services devoted to the tracking of such transactions, is that the underlying stock price movement immediately subsequent to such transactions is predictable to a statistically significant level, thus ripping the pants off of random walkers.

Tim Knows How to Make Stuff Up said...

Ron, the cool thing about Renaissance is not so much the amount of profits, but how they are doing it, trading, real trading, not this "swing trade" stuff which isn't much different from stale B&H approaches.
I thought the NYT article was great. It was particularly satisfying to me as I have been working for a long time, as I suspect many other fans of TA have, to find "predictive patterns." One of my proprietary trading models is based upon this very concept. Having said that, my model is not tied to a specific time frame, but I still believe it falls under the predictive price pattern that Simons alluded to. The major difference, I suspect is that the Simons is capturing his returns on what I would term "nanotrades." So, while we may not be in the same pew, I think we are in the same church.
Many thanks for the heads up about SVA.

Anonymous said...


I'm still at the point where I base my investments on projected valuation. Some of the strategies you've talked about in your blogs sound very appealing. What are the best websites or publications to get information on insider buying and reverse mergers? Thanks again.

Anonymous said...

Hi Allan,

Hope you're doing great.

Have you dropped any items from your flu basket?

What's your read of the bird flu in the news? I remember you answering someone else's question about how long you'll hold onto your basket--as long as bird flu is prominent in the news (did you say front page?). It seems to me that it's beginning to be percieved as a lot of hype. I'm thinking it's hard for the stocks to jump again like they did before based only on hype. And while I'd love for the stock to go to the moon, I'm not hoping they do so because of a genuine outbreak. Can hype and worry alone keep get these trending (or gapping) up again?

What do you think about HEB? Buy more right about now, hold on carefree, hold and get ready to dump, or something else?



ilene said...

It was particularly satisfying to me as I have been working for a long time, as I suspect many other fans of TA have, to find "predictive patterns." One of my proprietary trading models is based upon this very concept.

Tim: Well, I'm curious, can you explain your proprietary trading model? - Ilene

Tim Knows How to Make Stuff Up said...

Tim: Well, I'm curious, can you explain your proprietary trading model? - Ilene
I could explain the model, but then I'd have to...anyway, while I am very confident of the base theory, I am still in the process of refining the models because I want to make sure that they will work in a bear market, not just a sideways or bullish mkt like we had this year. In fact, since I have a day job similar to Allan's prior career, at this time, I use adjusted forms of my model to create longer swing trades to go along with my b/h plays. The reason I felt some vicarious satisfaction when I read the article is that, according to my research, my model(s) would be even better suited to developing an algorithm to implement on a more rigid basis.

Anonymous said...

I am also interested in opinions about the state of the bird flu stock saga. Are we at the end or is there still some life left in this sector?

A said...

I am also interested in opinions about the state of the bird flu stock saga. Are we at the end or is there still some life left in this sector?

I think we're at the beginning stages of nice run in these stocks. The basket approach gives a better chance of holding a big winner, then putting all your speculative dollars in one stock.....unless it was NNVC two months ago.