Most Successful Hedge Fund Ever

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Happy Sunday

I'm giving a warning in advance; this is quite a bit longer than what I normally do.

Jim Simons was quite the character so naturally, he deserves quite the write up for building the most successful hedge fund ever: Renaissance Technologies.

Here is how Simons explained his career: "I did a lot of math. I made a lot of money, and I gave almost all of it away. That's the story of my life."

The definitive source on Simons is The Man Who Solved The Market, a (highly recommended) book from 2019 written by author and Wall Street Journal writer Greg Zuckerman. Simons rarely spoke on the record but he spent hours with Zuckerman, who shares a lot of RenTech data in his book.

The iconic Medallion Fund — which was created by Simons' investment firm — made an astonishing $100B in trading profits from 1988 to 2018.

To understand how, let's discuss:

• The Making of Renaissance Technologies

• The Medallion Fund's Secret Sauce

• Simons' 5 Life Principles

The Making of Renaissance Technologies

At the age of 40, Jim Simons left a renowned career in math to start what would become Renaissance Tech ("RenTech"), the most successful hedge fund ever.

The crown jewel of RenTech is the Medallion Fund. Launched in 1988 — a decade after Simons started investing — the fund posted an annual gross return of 66% for the next 30 years (39% after fees). A single $1 invested in 1988 would be worth $14m by the end of that run and even more now as the fund is still going strong.

Before creating what Bloomberg dubbed a "moneymaking machine like no other", Simons had lived a full life as a legendary mathematician.

• 1938: Born in Newton, Massachusetts

• 1958: At 20, he graduates from MIT with a Bachelors in Math

• 1961: At 23, he graduates from Berkeley with a PhD in Math

• 1964-1968: He works as a codebreaker for the NSA as part of the Institute for Defense Analyses. He is later fired from the NSA/IDA for telling Newsweek magazine about his opposition to the Vietnam War

• 1976: He is awarded the Oswald Veblen Prize for Geometry (He also founded the Chern-Simons form, which is a theory widely used in quantum computing)

• 1968-1978: He serves as the Chair of the Math Department at Stony Brook University, where he builds and leads one of the nation's top math faculties

While Simon's background is heavy on the academic side, he always had an interest in making money. Why? Mostly as a way to ensure his professional freedom and allow him to pursue his own interests.

In his early 20s, Simons took a $5k wedding gift and learned to trade soy futures. After making a small profit, he gave up trading for decades. But another business venture would provide the seed funds for Renaissance Technologies: during his graduate days at MIT, a Colombian classmate started a business and Simons invested.

Fast forward to the 1970s. His Colombian classmate scored an exit, which provided Simons with extra funds to start trading commodities while running Stony Brook's math department. The side investing was good enough that Simons — also going through a divorce — decided to leave academia and launch his own money management firm in 1978: Monemetrics.

At the time, there were two main investment approaches: 1) fundamental (understanding and forecasting an asset based on key drivers); and 2) technical analysis (studying price charts).

Simons' strategy was to place a "fundamental lens" on currencies (e.g. tracking supply and demand). While Monemetrics experienced moderate success, Simons referred to the emotional swings of day-trading as "gut-wrenching". He desired a more systematic method, and thus set out to create a third approach: using complex mathematical models to identify signals that anticipate price movements.

As a former codebreaker, Simons believed that "there are patterns in the market" and that he could "find them". The job of finding these patterns was not for MBAs, but for PhDs and scientists. His first hires were former colleagues from Stony Brook and the NSA.

In 1982, he renamed the firm Renaissance Technologies.

It took years, but RenTech created a 3-step process to find "statistically significant moneymaking strategies" (aka signals):

1. Find an anomalous pattern in historic pricing data

2. Be statistically significant, non-random and consistent over time

3. Be somewhat explainable

These signals were called "tradeable effects". While many are now common in quant funds, RenTech did them first and did them better.

Some notable trading themes were:

• Mean-Reversion: Prices tend to revert after moving higher or lower (one RenTech employee said "we make money from how others react to prices")

• Trending: RenTech accurately predicted how long an investment would continue to move in a trend (whether up or down)

• Economic Releases: Prices for some assets fell right before and gained right after an economic release (e.g. labor statistics)

• Seasonality: Monday's price action was similar to Friday's while Tuesday's saw a reversion to previous trends

• Trader Habits: Commodity traders would sell a position on Friday so they wouldn't hold an asset if something happened on the weekend

In 1988, the single trading model — which would always remain a single model — officially became the Medallion Fund (named after one of Simon's math awards).

The first fund was $20m.

Early returns were meh…

• 1988: +16%

• 1989: +1%

…but then BOOM GOES THE DYNAMITE:

• 1990: +78%

• 1991: +54%

• 1992: +47%

In 1993, Simons decided to stop accepting outside money for the Medallion Fund. He also increased the fees for investors, including employees. Everyone agreed to the new terms, which resulted in fees going from "5% management and 20% performance" to "5% management and 44% performance".

A 44% performance fee may seem excessive, but Renaissance Technologies ultimately became owned solely by its employees and alumni. This was a smart incentive structure that helped attract and retain top talent. The high fees also allowed younger employees to be compensated well as they took on more responsibilities while other members retired or left the company.

At the same time as the change in management fees, Simons made personnel moves that would define RenTech for decades. He hired a number of scientists and PhDs from IBM's Thomas Watson Research Centre. Its speech recognition unit yielded RenTech's future Co-CEOs: linguists Rob Mercer and Peter Brown.

As an IBM colleague observed, "Speech recognition and translation are the intersection of math and computer science." Mercer and Brown actually pitched IBM to apply computational stats to manage its $28B pension. IBM said "no" and they (along with others) joined Simons.

RenTech's poaching of the IBM team opened up the world of tradable assets. Up until that point, Medallion had gained nearly all of its profits from currency and commodity futures. With the incorporation of algorithm design and coding skills from IBM, the fund was able to add thousands of equities to its model. This allowed the fund to increase its size.

The fund never grew too large, however, as the short-term nature of its strategies restricted how much money could be invested. The fund's current size is capped at ~$10B, with annual profits being distributed to alumni and over 300 employees, 1/3rd of which hold PhDs.

The limited fund size and the fact that the money barely compounds make the total cash generated — over $100B in profits — all the more remarkable. After deducting its large 5/44 fees, the annualized return for Medallion from 1988 to 2018 was an outrageous 39% (compared to an even more impressive gross return of 66%).

Interestingly, the fund only won 50.75% of its trades. An army of top PhDs are basically a coin flip in trading. Markets are hard AF (most should just buy and hold).

Mercer has perhaps the most quotable quote of the entire Renaissance Technologies story: "We're right 50.75% of the time, but we're 100% right 50.75% of the time. You can make billions that way."

Add it all up and the Medallion Fund's returns (1988-2018) are absurd:

• Since 1990, its worst year is +32%

• In 24 of the 31 years, it was up at least 50%

• It had three 100%+ return years, all in the worst market conditions: 2000 (+128%), 2007 (+137%) and 2008 (+152%)

Here are four more details of the RenTech story worth flagging.

First, when you make $100B in trading profits, the IRS is going to take a very close look at your taxes. In 2021, RenTech paid $7B to settle a dispute over how the firm classified its trades over the decades. The gist is that RenTech was booking its derivative trades under "long-term capital gains" when they were actually short-term gains (which are taxed at a higher rate). That is one painful back-tax payment.

Second, Simons officially retired from RenTech in 2009 but remained involved in high-profile management issues. A lifelong Democrat, he had to deal with controversy surrounding Robert Mercer, one of Donald Trump's top donors in 2016. Mercer stepped down from Renaissance Technologies in 2017 (Peter Brown remains CEO).

Third, RenTech has been offering institutional funds to outside investors since 2005. It started with the Renaissance Institutional Equities Fund (RIEF) and has since launched two other funds. Together, these funds manage over $50B. However, their performance has been really lacking in recent years with the funds significantly underperforming the S&P 500. Translation: the RenTech magic has its limits.

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The Medallion Fund's Secret Sauce

How was the Medallion Fund able to pull it off?

The actual secret sauce remains secret. Anyone who knows even a modicum of how it works isn't sharing the information because they've signed a fat NDA and have zero interest in missing out on those sweet distributions. Some funds did poach ex-RenTech employees, but lawsuits were filed.

Still, there are some high-level details that help to explain the fund's wild performance. Here are 9 of them drawn from Zuckerman's book and also this series of fireside chats with MIT's Andrew Lo.

1. Simons is an incredible leader

From his days at Stony Brook University, Simons has long experience managing intellectual egos. His academic credentials and trading chops earn universal respect.

People with Simons' brain usually don't have that level of EQ and people with that level of EQ don't usually have his brain. Per Bloomberg, Simons is the "benevolent father figure" that inspired "super nerds to stick together."

2. Culture for top talent

One primary aspect of Simons' job was to establish a desirable place for high-level scientists to be motivated to work. Here are his thoughts on developing RenTech's culture:

Another aspect of collecting the best talent is that Simons had everyone pulling in the same direction by contributing to the single model.

Academia can be very zero-sum, with PhDs fighting over the same honors and pool of grant money. Similarly, many investment firms pit fund managers against each other, with top performers receiving money and accolades.

At RenTech, everyone wins when the one trading model is successful. This aligns incentives and fosters cooperation.

3. Never override the computer

The driving logic behind RenTech was to create a systematic trading approach that wouldn't be compromised by human emotion. The Medallion Fund has performed the best during volatile times, because it lets the model run while everyone else is losing their minds.

Per Simons:

Apparently, RenTech did override the model once during the "Quant Quake" in 2007 but it was an exception that proves the rule.

4. Data edge

RenTech's unofficial motto is "There's no data like more data." It was a pioneer in gathering and cleaning data. The team collects data of various types, such as weather, prices, and newspaper blurbs, for its model earlier than most other funds. Today, its system ingests one terabyte of data per year in order to improve the trading model.

5. Great execution

RenTech makes 150k-300k small trades per day, with holding periods of ~2 days. A crucial aspect of their trading model is accurately estimating the bet size to minimize any negative effects on the trade (which RenTech refers to as "slippage" for transaction costs).

6. "Don't ask why"

RenTech believes that market participants vastly underestimate how many variables drive an asset. The team rarely offers hypotheses. Instead, they let the data speak and if a signal works — even if they don't fully understand why — they will trade it.

7. Stealth trading

When RenTech finds a market inefficiency, it goes to great lengths to not give away the trade.

Here is an excerpt from The Man Who Solved The Market:

8. Extreme diversification

The move into equities allowed RenTech to trade in many more assets (and deploy up to $10B per year). At any one time, the Medallion Fund can have 4k long and 4k short trades.

Such a diversified portfolio reduces overall risk, giving RenTech access to…

9. …Leverage

Having built a trading machine with the best data and execution combined with diversification, banks (e.g. Deutsche, Barclays) are happy to lend RenTech money.

Medallion typically leverages 12.5x (and often goes as high as 20x). Without leverage, its returns are comparable to those of the S&P 500.

As the late Charlie Munger once said, "Smart men go broke three ways: liquor, ladies and leverage." RenTech's next-level risk management — and trading record — gives its partner banks confidence to provide leverage. Few other firms will ever get such a long leash (and even if they did, they wouldn't know how to handle it properly).

Simons' 5 Life Principles

In the final decade of his life, Simons (and his wife Marilyn) were primarily focused on philanthropy. Through their Jim Simons Foundation and the Flatiron Institute, the Simons donated billions to scientific research in the search for signals, specifically in the fields of math, astrophysics, biology, and quantum physics.

"I just made the money and Marilyn gave it away," Simons said of his philanthropic efforts.

For all his success, Simons says "luck plays quite a role in life". He's also dealt with very bad personal luck: losing two sons in separate accidents. When asked about the losses, Simons once remarked to a colleague, "my life is either aces or deuces."

Taken all together, Simons has laid out his five life principles:

1. Don't run with the pack: "Try to do something that's original."

2. Collaborate with wonderful partners: "Find someone that's smarter than you that can leverage your efforts."

3. Be guided by beauty: "It's easy to find a nice aesthetic in a math formula, but you can find beauty in many other enterprises. A well-run business is kind of a beautiful thing."

4. Persistence: "Something that's really worthwhile can take a lot of time to come to fruition and you ought to have patience. If you believe in something, just stick with it."

5. Hope for good luck!

These principles are much more applicable than trying to replicate the Medallion Fund's $100B secret sauce. Countless investors have tried for decades but failed to reach the same heights. Even RenTech can't replicate a fraction of the performance for its institutional funds.

Remember, it's "like no other".

My main takeaway from the story is how it's never too late to start something new. Simons gave up his academic career at 40 and became arguably the greatest investor ever.

Anyone can try creating something using principles #1 (be original) and #2 (finding wonderful partners). Then, build it with principles #3 (be guided by beauty) and #4 (be persistent) while keeping in mind that #5 (hoping for good luck) is largely out of our control. However, if you have the other four principles in place, it's a solid start… at any age.

Stay curious 🙂 

- John