Book review: 'The Man Who Solved the Market' by Greg Zuckerman
Updated: 17 hours ago
Introduction
'Star' fund managers are often in the news, sometimes for the wrong reasons. Regarding media profile, some hedge funds tend to be at the opposite end of the spectrum, shunning attention at all costs.
For those interested in the most secretive of these firms, 'The Man Who Solved the Market: How Jim Simons Launched the Quant Revolution' is a must-read book. I first read it soon after it was released in late 2019, but with the return of the Great British Summer, I recently spent some time rereading it under the old oak tree in the garden. The book details the story of James Simons and Renaissance Technologies (Rentec), the hedge fund he founded.
Early days
James worked as a codebreaker after studying mathematics and receiving a bachelor’s degree from the Massachusetts Institute of Technology (MIT) and a Ph.D. from the University of California. He also taught mathematics at MIT and Harvard before becoming chairman of the Maths Department at Stony Brook University.
Simons founded his first hedge fund, Monemetrics, in 1978. The successor, RenTec, was launched in 1982, and their flagship Medallion fund in 1988. After mixed success, Simons, along with Elwyn Berlecamp, changed their investing approach in 1990, which, up until this point, had been to trade traditionally, using human intuition in an attempt to make money. Simons said, 'If we have enough data, I know we can make predictions.' They planned to remove the human element from making trading decisions.
Trading strategies
This new approach involved hiring specialists from non-financial backgrounds, typically mathematicians, physicists, signal processing experts and statisticians. This team has been described as 'the best physics and mathematics department in the world'. Their job was to analyse vast amounts of historical market data, hoping to determine some predictability amongst all the seemingly random and chaotic noise. Traditionally, there had been two approaches to investing: fundamental and technical analysis. The new approach had similarities to technical analysis but was much more sophisticated, relying more on maths, science and data than trying to find patterns in charts.
One strategy would be to predict how one company's share price might do relative to the share price of another similar company. For example, they might believe BP’s share price will go up more than Shell’s, so they buy BP shares and sell Shell shares. If they are correct, they will make more money on BP than they lose on Shell, and overall, this strategy is broadly market neutral, meaning it is unaffected by general market movements. This strategy was pioneered by Gerry Bamberger at Morgan Stanley in the 1980s and is known as pairs trading.
RenTec built this and many more complex strategies that ran on powerful computers. These strategies submitted thousands of trades per day across various asset classes, expecting each trade to generate a small profit on average. These strategies were able to run without human intervention.
Rentec, along with other large quant funds such as D.E Shaw (where Jeff Bezos worked before launching Amazon), have now been trading this way for decades. Indeed, it was estimated that D.E. Shaw alone traded as much as 5% of the daily volume on American stock markets pre-1998.
Successful money maker
Rentec is considered by many to be the most successful money-maker in recent history. Their Medallion fund, now mostly run for employees, returned 66% annualised before fees over a 30-year span from 1988 to 2018.
In 1994 the team pondered who the losing party might be on the other side of Rentec's winning trades. They concluded that it was most likely private investors attempting to predict the market's future direction. 'It’s a lot of dentists!', Henry Laufer said. Krešimir Penavić stated, "Humans are most predictable in times of high stress - they act instinctively and panic. Our entire premise was that human actors will react the way humans did in the past, and we learned to take advantage".
Rentec launched another fund in 2005 named Renaissance Institutional Equities Fund (RIEF). This fund differed significantly from Medallion in that it was focused purely on equity markets and took longer-term bets on the markets, with trades sometimes lasting a year versus typical holding periods of a few days for the Medallion fund.
Having an edge
Beating the market is all about having an edge. In the case of Rentec, and more specifically, the Medallion fund, these included:
1. Huge brainpower
If you consider some of the individuals involved in Rentec alongside Simons over the years, you can see the brainpower involved in building the business. For example:
Leonard Baum: Developed the Baum–Welch algorithm and Baum–Sweet sequence.
James Ax: Was awarded the Cole Prize in number theory.
Elwyn Berlecamp: Developed numerous algorithms.
2. Enormous computer processing power
The book doesn't mention Rentec's computer setup, but this article suggests that their computing power increased by a factor of 50 between 1994 and 2000. Two Sigma, another highly regarded quant fund, could undertake more than 100 trillion calculations a second, according to a 2017 article.
3. Vast amounts of good quality market data
Rentec has both:
Vast amounts of data: Rentec is rumoured to have a Petabyte scale data warehouse: A petabyte is equivalent to 11,000 4k movies!
Good quality data: Sandor Straus (recruited from Stony Brook) was researching, building and most importantly, cleaning (removing trading gaps, errors etc.) data over 40 years ago.
Lots of good quality data is key when attempting to find very weak signals in a noisy dataset.
4. Cheap leverage
Medallion used to leverage up to 20 times at certain points, apparently available on favourable terms due to the firm's high Sharpe ratio.
5. Limiting the size of the fund
Medallion is rumoured to be capped at $10 billion. Most trading strategies tend to have a limit on how much can be invested before the edge goes away (larger trades tend to "move the market" more, meaning you are less likely to obtain the price you expected when making a trade). In 2003, Simons began to hand money back to external investors as he was worried the fund was getting too big, preferring his employees keep all of the gains.
6. Keeping a low profile
Simons once quoted Benjamin, the donkey in Animal Farm, which reflected his view on publicity; "God gave me a tail to keep off the flies. But I'd rather have no tail and no flies". Rentec were understandably very keen to keep a low profile. The fewer people who knew about their operation and successes, the longer their edge(s) would remain. They were also protective of their setup.
7. Having a strong survival instinct
In addition to all of the above, there were occasions when Simons displayed a strong survival instinct. In 1990, Rentec held its position with the Stotler group. Simons heard a rumour that Stotler was in trouble and asked the team to move the trades elsewhere, saying, "When you smell smoke, get the hell out". Soon afterwards, Stotler filed for bankruptcy
In 2007, during the infamous quant quake, the Medallion fund was down 20% in one week. Simons made the decision to overrule the models and start selling down, saying, "Our job is to survive".
8. Relatively short holding periods
Compare the returns of the Medallion fund, which has a typical holding period of a few days, to the funds available to external investors (e.g. RIEF) with a much longer investment horizon, and you can see how the returns differed. Simons compares the different approaches on Brian Keating's (James Ax's son) podcast.
Even with all the above, Robert Mercer stated that the fund trades were right only around 50.75% of the time. However, if you multiply this edge by hundreds of thousands of trades per day, you can see how the profits started to mount up.
Conclusion
There are a number of lessons to take away from this excellent book:
The Medallion fund shows that the market isn't fully efficient over shorter time horizons.
Immense resources are required to exploit these inefficiencies/edges.
Firms like Rentec (and there are many others!) tend to remove these shorter-term inefficiencies, meaning the market is broadly efficient for the remaining market participants.
The funds with an edge are unlikely to be available to external investors.
There is less evidence to suggest inefficiencies exist for those using strategies with longer holding periods.
The firms with an edge in the marketplace tend to be secretive. Peter Brown once said, "Any time you hear financial experts talking about how the market went up because of such and such - remember it's all nonsense". It's worth remembering next time you hear market commentary on market events. This extends to future predictions (e.g. the S&P will be at 3,000 by the end of the year). Based on the above, you can see how seriously you should take someone making those predictions!
Every time you or your fund manager trades, it's important to appreciate who may be on the "other side" of the transaction. Realistically, it's unlikely that you or your fund manager will know more than firms such as Rentec, so it's important to keep trading (buying and selling) to a minimum.
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