Inside The Machine: How Algorithmic Prop Trading Strategies Turned The Medallion Fund Into A Mathematical Powerhouse (2024)

In his 2019 book "The Man Who Solved The Market," author Greg Zuckerman describes Renaissance Technologies frontman Jim Simons standing outside his Manhattan, New York, office with his trademark Merit cigarette dangling between two fingers. While a chain-smoking hedge fund manager might seem like a relic of past times, Simons is anything but a dinosaur. The math whiz from the Massachusetts Institute of Technology (MIT) ditched academia to build one of the most potent profit builders in finance — the Medallion Fund.

Trust The Models

Simons didn't envision himself as a hedge fund manager. After getting his Ph.D. from the University of California, Berkeley, Simons had several unique jobs: codebreaker for the National Security Agency (NSA), math department chair at Stony Brook University and founder of Math for America. But in 1978, Simons set his sights on what would become his life's most prominent work — the quantitative trading firm Renaissance Technologies.

Simons and his team of mathematicians, statisticians, and data scientists care little for the underlying businesses of their investments. Fundamental analysis, valuation, or future catalysts aren't generally on Renaissance's radar. Co-founder Robert Mercer referenced Chrysler stock when discussing the hedge fund's strategies, even though Daimler AG had absorbed Chrysler and was no longer publicly traded.

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Instead, Renaissance traders focused on price patterns, so Simons preferred math and data scientists to economists and financial analysts. The flagship Medallion Fund opened in 1988 and uses sophisticated computer models to build automated trading systems in highly liquid markets. While algorithm and computer-based trading were hardly revolutionary, Simons perfected the art with Medallion thanks to the vast swaths of data his firm could digest.

Following a reconfiguration with some help from an old Berkeley professor, Medallion took off in 1991 with a 39% return. What followed would become one of the most impressive runs Wall Street has ever seen.

Remarkable Performance And Fees

The inner workings of the Medallion Fund have been notoriously opaque for decades. But from what is known, Medallion’s public returns have been astonishing following the reconfiguration in 1990 by Simons and Professor Elwyn Berlekamp. Here's how Medallion did between 1990 and 2000 (after fees):

• 1990: 58.2%
• 1991: 39.4%
• 1992: 33.6%
• 1993: 39.1%
• 1994: 70.7%
• 1995: 38.3%
• 1996: 31.5%
• 1997: 21.2%
• 1998: 41.7%
• 1999: 24.5%
• 2000: 98.5%

Source: Cornell Capital

After 2000, Medallion raised its fees to 5% fixed and 44% performance, some of the highest in the industry. But returns continued to be staggering. As of this writing, Simons's high-frequency pattern recognition machine has produced an average annual return of 39.2% over 30 years of trading.

Lessons On Scaling

The Medallion Fund has been closed to outside investors since 1993, and all shareholders, minus current and former employees and their families, were bought out by 2005. Simons retired as Renaissance CEO in 2009 and left the business entirely in 2021. Some in the investment community wonder whether Medallion's returns are questionable because of the lack of audits, especially since Renaissance's other fund offerings (like RIEF) fail to meet Medallion's lofty standard.

However, Medallion is a closed fund with high position turnover and quick and frequent trading. Simons might have a special sauce, but it fails on a large scale. This is far from a unique problem; many businesses are bursting with great ideas that aren't scaling to the public. By limiting his fund’s capital, Simons could effectively maneuver his strategies.

A good lesson for all potential prop traders lies at the heart of this story. Just because a system works in a $10,000 account doesn't mean it will work in a $10 million account. Finding a balance is crucial, which is why so many new prop traders fail.

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