God and RenTech’s black box

By Felix Salmon
June 25, 2010
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 – “it can’t just be statistically valid”. 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.

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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 – “it can’t just be statistically valid”. 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.

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10 comments so far

Reminds me of this Radiolab segment about computers that spit out algorithms that explain relationships, even though we can’t understand/intuit why the relationship exists:
http://audio.wnyc.org/radiolab/radiolab0 41610c.mp3
I <3 Hume

Posted by jiminy_c | Report as abusive

“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.”

The speaker’s simply contributing to the aura that surrounds quantitative finance. Quants love to portray their work in the imagery of alchemists divining the secret laws of the heavens and the world. Unfortunately, many journalists are more than happy to oblige (cue Scott Patterson of the WSJ).

The reality is that the inference techniques used by quant funds are not too far from those used by academics in the natural and social sciences, bioinformaticians at Pfizer, engineers at Boeing, market researchers at Nielsen, or search engine designers at Google.

Also, the whole idea of using factors and signals that are non-intuitive happens all the time across many fields. Consider principal components analysis (PCA). Would you consider the factors it outputs to be non-intuitive? Yes, it lacks the robustness of models that progress from an intuitive theoretical model, but I would consider it a fairly standard, understandable, and robust (under specific cases) technique for statistical inference.

Lastly, I would recommend that you rarely believe quants when they boast that their signals are unique. The original ideas are sometimes brilliant, but a large majority of signals I’ve come across have been variations on a theme. Often, what makes a difference between a profitable signal and an unprofitable signal is not the actual signal itself but rather the technology with which you can implement it, the operational sophistication of the firm, the coding ability of its IT developers, and the culture of the team within which they work.

Posted by agathocles | Report as abusive

1. Isnot there asimple explanation. You can start with something in 2 ways:
-start from the theorie
-start with statistical info.
2. Subsequently you assure yourself by testing the theory in practice resp. find a logical explanation for the statistical findings.
3.The latter you can of course also do by new (future) testing if it shows that it works not only in the past, there is a high probability that there is a correlation.
4.Of course spreading your risk if you donot have a logical explanation yet reduces the overall risk even more. Limit your exposure on one bet and keep looking for the logic.

Posted by Rikh | Report as abusive

Now Felix, let’s not get metaphysical.

It could just be the old shell game: shape the return curve so that returns increase, volatility decreases and third moments & higher all increase. Setting yourself up for a larger disaster, sometime later.

Posted by loopguy | Report as abusive

I’m a bit saddened by this one Felix.

Agathocles is right on point. Typical spewing from quants.

Posted by chaetodon | Report as abusive

Renaissance, formerly synonymous with the resurgence of learning as a means to escape the gravitational pull of theocratic darkness… From that to this:

“We’re not sure and frankly don’t care whether money revolves around the sun god, or vice versa. Just pay The Man, and don’t forget to tell him the Oracle sent you!”

Posted by HBC | Report as abusive

I’m reminded of neuroscience evidence that people tend to decide what they’re going to do subconsciously and only use the conscious mind to rationalize the decision after the fact. (Much like financial journalism.) Some things are just harder to pretend we understand than others.

Posted by dWj | Report as abusive

I slept on this and I am still back to the original thought i had, about the man who had made a perpetual motion machine and everyone was astounded.

That is might not be real meant nothing to the throngs of educated, uneducated, scientist and engineer who gawked in awe as it moved seemingly to infinity.

The fact is it had a little winder inside that an insider secretly wound up every night with a special key

The perpetual money machine. Eureka!

Posted by hsvkitty | Report as abusive

Isn’t this what the Fama-French three factor model does? It generates what looks like alpha according to the CAPM for no good reason. I’m not sure what the point of this post is. How can we discuss their models or their trades if we don’t even know what they are?

Posted by JimmyJimmington | Report as abusive

I dunno if you read old comments, but Rich Jim and company used to be codebreakers. Yeah, you could call weird stuff a “potentially spurious correlation that makes no sense.” Or you could know something about information theory and code breaking, and know that your spurious correlation is statistically certainly telling you something about some underlying market mechanism you don’t quite understand. That’s more or less my point about their trading weird patterns. They probably don’t have economic models for what is happening, but I guarantee they have sound probabilistic models.

Not that I’d know anything about this and stuff.

Posted by slocklin | Report as abusive
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