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The most successful money maker in modern history vs star fund managers

“Star” fund managers are often in the news, sometimes for the wrong reasons.

In terms of media profile, hedge funds tend to be at the the opposite end of the spectrum, shunning attention at all costs.

For those that have an interest in the most secretive of these firms, a must read book1 was released last week. It details the story of Jim Simons and Renaissance Technologies (Rentec), the hedge fund he founded.

After studying mathematics and receiving a bachelor’s degree from the Massachusetts Institute of Technology (MIT) and a PhD from the University of California, Jim worked as a codebreaker and taught mathematics at MIT and Harvard before becoming chairman of the Maths Department at Stony Brook University.

He founded his first hedge fund Monemetrics in 1978 which was the predecessor to RenTech, launched in 1982.

After mixed success, Simons, along with Elwyn Berlecamp changed their investing approach in 1990 which up until this point had been to trade in a traditional way, using human intuition in an attempt to make money.

Simons said, “if we have enough data, I know we can make predictions.” Their plan was to remove the human element from making trading decisions.

Pairs trading

This new approach involved hiring specialists from non-financial backgrounds; typically mathematicians, physicists, signal processing experts and statisticians. This team of people has been described as “the best physics and mathematics department in the world”, and their job was to analyse petabytes worth of market data hoping to determine some predictability amongst all the random and chaotic noise.

One strategy would be to predict what the share price of what one company might do in relation to the share price of another, similar company.

For example, they might believe BP’s share price is going to go up more than Shell’s, so they buy BP shares and sell Shell shares. If they are correct they would 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 type of strategy was developed in the 80s and is known as pairs trading2.

RenTech built this and many, many far more complex strategies that ran on powerful computers. These strategies submitted numerous thousands of trades per day across various asset classes, with the expectation that each trade would, on average, generate a small profit.

All this was done without human intervention.

Multiply this small profit by the number of trades and add a healthy dose of leverage, and if successful, the profits can, and were proven to be, very substantial.

Successful money maker

Rentech is considered by many to be the most successful money maker in recent history. Their flagship Medallion fund, which is now mostly run for employees, returned 66% annualised before fees over a 30-year span from 1988 to 2018.

Rentech, along with other large quant funds such as D.E Shaw have 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 19983.

In 1994 the team pondered who the losing party might be on the other side of the winning trades Rentech were making. Their conclusion was it was most likely private investors that thought they could predict the direction of the market. “It’s a lot of dentists!”, one employee said.

Rentech launched another fund in 2005 named Renaissance Institutional Equities Fund (RIEF). This differed slightly 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.

So what has Rentech got to do with star fund managers?

Compare and contrast

Beating the market is all about having an edge. With some of the brightest brains, enormously powerful computers crunching huge amounts of data, Rentech has just that.

But even with their undoubted ability, they can’t predict the overall long term direction of the market nearly as successfully as they can exploit short term price inefficiencies – this is demonstrated by the relative differences in performance between their Medallion and RIEF funds, the former having far outperformed.

Contrast Rentech’s setup with that of an active fund manager.

Of course, fund managers are very intelligent, but so are the other participants in the market they are competing against. Do they have a genuine edge here?

Unfortunately, not everyone in the market can be a winner; indeed the average active manager returns trails the overall market return after costs4 and picking winning fund managers that have persistent out performance is difficult, if not impossible5.This is understandable considering what they are up against.

Chess moves

Deep Blue vs Garry Kasparov was a chess tournament that took place in 1996 (with a rematch in 1997) between a world chess champion and an IBM computer. Kasparov won the first series 4-2 while losing the rematch 3.5-2.5.

When you consider how complex the financial markets are relative to chess, and also how far computers have come in the last 20 years, you have to wonder for how long the human fund manager will remain in business given their competition gets more powerful each passing year.

Kasparov had the following to say “Today you can buy a chess engine for your laptop that will beat Deep Blue quite easily”.

One interesting footnote –  during the 2018 market selloff Simons got nervous and phoned his personal adviser suggesting they short the market (bet on the market going down further) to reduce losses in case the selloff got worse. His adviser suggested keeping calm.

The next day the falls were over and the market stabilised. Even one of the world’s greatest investors benefited from a guiding hand.

Lessons to learn

The key points to take away from this are:

-beating the market is extraordinarily difficult.

-even if you were able to outperform the market, but still felt short of your objectives – would that be considered a success?

-a trusted adviser that keeps you on track during turbulent times can pay for themselves many times over.

We feel it’s far better to:

-focus on the things you can control.

-have a robust financial plan in place that can deal with life’s unexpected events

-consider accepting the returns of the market using a globally diversified portfolio

-leave the market beating to Renaissance and other similar firms – masters of the markets!

If you found the above interesting and want to have a chat, please give me a call on 01932 645150 or email noel@pyrfordfp.com.

  1. https://www.amazon.co.uk/Man-Who-Solved-Market-SHORTLISTED/dp/0241422159/ref=sr_1_1

  2. https://en.wikipedia.org/wiki/Pairs_trade

  3. https://thehedgefundjournal.com/the-waxing-and-waning-of-demand/

  4. https://us.spindices.com/spiva/#/

  5. https://www.evidenceinvestor.com/persistent-outperformance-remains-very-elusive/

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