God and RenTech’s black box
Does Renaissance Technologies — arguably the most successful hedge fund in the history of the world — know why it makes as much money as it does? A couple of weeks ago, I thought that it did, after reading a piece about RenTech’s Robert Frey in the FT. One of the fund’s four principles, he said, was rationality â€“ â€śit canâ€™t just be statistically validâ€ť. You have to employ reason to identify a statistically significant but spurious pattern — which meant, I thought, that RenTech had a common-sense test: it wouldn’t enter into a strategy without having some kind of grip on why that strategy should work.
Ryan Avent, at the Economist, was unconvinced:
According to Sebastian Mallaby’s new hedge fund history, “More Money Than God”, the willingness to explore unexplained correlations is what sets Renaissance apart from other quant funds… The firm’s advantage is in its willingness to trade what doesn’t necessarily make sense…
Mr Frey is obviously in a better position than I am to know whether Renaissance does or does not require some theoretical model to be in place before trading on a signal can begin. But having the guts to trade relationships no one else can understand or explain would be one way to consistently beat the market over a period of two decades.
Scott Locklin, for one, thinks that’s ridiculous. Trading a relationship no one can understand or explain, he says, is “how you lose all your money in two weeks”. True scientists, says Locklin, of the type hired by RenTech, are trained to look for actual rather than spurious correlations, and to be able to tell the difference.
So, who’s right? Sebastian Mallaby would seem to be the best person to ask, here, since he spent a lot of time with RenTech types researching his doorstop of a book. So I asked him, and got this back:
The answer is that it is willing to trade stuff in the absence of intuitive explanations, and that this sets it apart from DE Shaw. But RenTech feels more comfortable when there is an intuitive explanation because that reduces the danger of data fitting errors.
Mallaby even quotes RenTech’s Bob Mercer to that effect in the book (page 302, for those of you following along at home):
“If somebody came with a theory about how the phases of Venus influence markets, we would want a lot of evidence….(But) some signals that make no intuitive sense do indeed work…the signals that we have been trading without interruption for fifteen years make no sense. Otherwise someone else would have found them.”
It’s weird, but if you believe Mallaby and Mercer, it’s true: somehow RenTech discovered a secret formula for making money. Follow the rules it spits out, and you’ll be rich, even though the formula makes no visible sense at all.
Does such a formula really exist? Is it as simple as finding it, keeping it secret, and doing whatever it tells you to do? Does that explain why the Medallion fund continues to do so well, even as RenTech’s other funds seem much more likely to come unstuck? And if such a formula does exist, would there have to be some deep reason why it works, which is just too recondite for mere mortals to work out? We’re entering the realm of the metaphysical here, which might be condign for a book entitled “More Money than God”. Maybe God — and only God — knows why James Simons is so rich, and maybe his formula is the modern-day equivalent of the Holy Grail.