EVERY SPOKEN WORD
150 min read · 30,030 words- 0:00 – 0:45
Intro
- BGBen Gilbert
I always used to misspell Renaissance as I was typing it out. I'd R-E-N, and then I would sort of, like, not really know what came from there, but I learned a mnemonic to make sure I get it right.
- DRDavid Rosenthal
Oh! I thought you were gonna say you've typed it so many times now over the past month.
- BGBen Gilbert
Well, there's that, too, but you ready for this? You can't spell Renaissance without AI.
- DRDavid Rosenthal
Oh, [laughing]
- BGBen Gilbert
[laughing]
- DRDavid Rosenthal
Touché, touché.
- BGBen Gilbert
Uh... All right, let's do it.
- SPSpeaker
Who got the truth? Is it you? Is it you? Is it you? Who got the truth now? Hmm. Is it you? Is it you? Is it you? Sit me down, say it straight, another story on the way. Who got the truth?
- 0:45 – 5:20
Why Renaissance Technologies matters: the best returns in investing history
- BGBen Gilbert
Welcome to season fourteen, episode three of Acquired, the podcast about great companies and the stories and playbooks behind them. I'm Ben Gilbert.
- DRDavid Rosenthal
I'm David Rosenthal.
- BGBen Gilbert
And we are your hosts. They say, David, that as an investor, you can't beat the market or time the market, that you're better off indexing and dollar cost averaging rather than trying to be an active stock picker. They say there's no persistence of returns for hedge funds, that this year's big winner can be next year's big loser, and that nobody gets huge outperformance without taking huge risk.
- DRDavid Rosenthal
When I was in college, I actually took an economics class with Burton Malkiel, who, of course, you know, was involved in starting Vanguard and is a big proponent of all that, and that is what I learned, Ben.
- BGBen Gilbert
Well, David, it turns out they were wrong. Today, listeners, we tell the story of the best-performing investment firm in history, Renaissance Technologies, or RenTech. Their thirty-year track record, managing billions of dollars, has better returns than anyone you have ever heard of, including Berkshire Hathaway, Bridgewater, George Soros, Peter Lynch, or anyone else. So why haven't you heard of them? Or if you have, why don't you know much about them? Well, their eye-popping performance is matched only by their extreme secrecy, and they are unusual in almost every way. Their founder, Jim Simons, worked for the US government in the Cold War as a codebreaker before starting Renaissance. None of the founders or early employees had any investing background, and they built the entire thing by hiring PhD physicists, astronomers, and speech recognition researchers. They're located in the middle of nowhere in a tiny town on Long Island. They don't pay attention to revenues, profits, or even who the CEOs are of the companies [chuckles] that they invest in. And at any given time, they probably couldn't even tell you what actual stocks they own. Now, you may be thinking, "Okay, great, I just learned about this insane fund with unbelievable performance," and to be specific, listeners, that's sixty-six percent annual returns before fees, "and, you know, well, I want to invest!" Well, you can't. To add to everything else that I just said, RenTech's flagship Medallion Fund doesn't take any outside investors. The partners of the firm have become so wealthy from the billions that the fund has generated, that the only investors they allow in are themselves.
- DRDavid Rosenthal
Oh, we are going to talk a lot about that towards the end of the episode, 'cause I think it's kind of the key to the whole thing.
- BGBen Gilbert
Ooh, cliffhanger, David. I'm excited. So what exactly does Renaissance do? Why does it work, and how did it evolve to be the way it is today? And while the resources that are out there are scarce, because, for one, employees sign a lifetime non-disclosure agreement, David and I are going to take you through everything we've learned about the firm from our research, dating all the way back before Jim Simons started as a math professor, to understand it all. This episode was selected by our Acquired limited partners, and to be honest, I didn't think enough people knew what RenTech was to pick it, but when we put it out for a vote, the people have spoken. So if you want to become a limited partner and pick one episode each season and join the quarterly Zoom calls with us, you can join at acquired.fm/lp. If you wanna know every time a new episode drops, sign up at acquired.fm/email. These emails also contain hints at what the next episode will be and follow-up facts from previous episodes. For example, we had a listener, Nicholas Cullen, email us this time, who found the actual document with the bylaws of Hermès's controlling family shareholder, H fifty-one, which we linked to in this most recent email. Come talk about this episode with us after listening at acquired.fm/slack. If you want more from David and I, check out ACQ2. Our most recent episode was with Lotte Bjerre Knudsen, who led the team that created the first GLP-1s at Novo Nordisk, so awesome follow-up to the Novo episode if you liked that one. Before we dive in, we want to briefly share our presenting sponsor this season is J.P. Morgan, specifically their incredible payments business.
- DRDavid Rosenthal
Yeah, just like how we say every company has a story, every company's story is powered by payments, and J.P. Morgan Payments is a part of so many companies that we talk about on Acquired. It's not just the Fortune five hundred, too. They're also helping companies grow from seed to IPO and beyond.
- BGBen Gilbert
Yep. So with that, the show is not investment advice. David and I may have investments in the companies we discuss or perhaps wish we did, and this show is for informational and entertainment purposes only. David, where do we start our story today?
- 5:20 – 13:26
Jim Simons’ early life: math talent, ambition, and “taste”
- DRDavid Rosenthal
Ah, well, we start in 1938 in Newton, Massachusetts, which is a fairly wealthy suburb just outside of Boston, where one James Simons is born. And both of Jim's parents were very, very smart, especially his mother, Marsha. His dad was a salesman for 20th Century Fox, the movie company. His job was he went around to theaters in the Northeast and sold packages of movies to them.
- BGBen Gilbert
Super cool.
- DRDavid Rosenthal
By the way, we know all this because we have to thank Greg Zuckerman, author of The Man Who Solved the Market, which is the only book out there that is solely dedicated to RenTech and Jim Simons, and we actually got to talk to Greg in our research. He helped us out a bunch. Thank you, Greg.
- BGBen Gilbert
And helped fact-check a few of our assumptions of what happened after the book came out.
- DRDavid Rosenthal
... So that was Jim's parents, but really a major influence on him growing up was his grandfather, Marsha's dad. There's already kind of echoes of the Bezos story here with the grandfather, the mother's father, and spending a bunch of time with him, and rubbing off on young Jeff or young Jim, in this case. And Bezos, of course, would get his start in his career at D. E. Shaw.
- BGBen Gilbert
A quant fund coming up at the same time as RenTech.
- DRDavid Rosenthal
But back to Jim here in the 1940s. His grandfather, Peter, owned a shoe factory that made women's dress shoes. Jim spends a ton of time there growing up at the factory. So Jim's grandfather, Peter, was quite the character. He was a Russian immigrant, and he's kind of, like, still more Russia than Boston at this point in time. [laughs]
- BGBen Gilbert
[laughs]
- DRDavid Rosenthal
As Greg puts it in the book, Peter reveled in telling Jim and his cousins stories of the motherland involving wolves, women, caviar, and vodka. And he teaches young Jim, when he's a child here in the factory, to say Russian phrases like, "Give me a cigarette," and, "Kiss my ass."
- BGBen Gilbert
Which I think he probably would say that thousands of times the rest of his life. [laughs]
- DRDavid Rosenthal
I think so. If you watch interviews with Jim, his hands are always twitching because he has chain-smoked his entire life, probably going back to, like, age ten in the factory.
- BGBen Gilbert
Three packs of Merits a day.
- DRDavid Rosenthal
Unbelievable.
- BGBen Gilbert
Although I think he quit later in life, but he definitely chain-smoked the better part of the first, call it, seventy-five years or something.
- DRDavid Rosenthal
I mean, there are these famous stories of the conference rooms at RenTech and the war rooms when the market is going through, like, a crazy gyration, and it's just filled with cigarette smoke, and it's all Jim. [chuckles]
- BGBen Gilbert
Different time.
- DRDavid Rosenthal
Different time. So back to Jim's childhood, though, here in the Boston suburbs. He grows up certainly not uber wealthy or uber rich, but very, very solidly upper middle class, and especially, he's an only child. He has all the resources of his parents, his family. His grandfather's this sort of well-to-do entrepreneur, and Jim, you know, he gets to rub shoulders in the Boston area with people who are really rich, and he says later, "I observed that it's very nice to be rich. I had no interest in business, which is not to say I had no interest in money." [chuckles]
- BGBen Gilbert
Yes, important to tease out the difference between those two things.
- DRDavid Rosenthal
Yes, very, very important. And what he means when he says he has no interest in business, it's because from a pretty young age, he gets really into math. So the legend has it, when Jim is four years old, he stumbles into one of Zeno's famous paradoxes from ancient Greek times.
- BGBen Gilbert
Yep, this is great. The basic gist of Zeno's paradox is if you are always taking a quantity and dividing it by two, you will never hit zero. You will asymptotically approach zero, but you will never actually touch zero. You need to do addition or subtraction to do that. Division won't cut it. And so Jim, as a four-year-old, when he observes they need to go to the gas station to fill up the tank, he throws out the idea, "Well, let's just use only half the gas in the tank, because then we'll still be able to, after that, only use half the gas in the tank." And you know, the funny thing that doesn't occur to a four-year-old is, well, then we're just not gonna get very far.
- DRDavid Rosenthal
So Jim's dream is to go to MIT, down the street in Cambridge, and study math. He graduates high school in three years, and during the second semester of Jim's freshman year there, he enrolls in a graduate math seminar on abstract algebra. So pretty, you know, heady stuff.
- BGBen Gilbert
Yeah, and Jim would go on to finish his undergrad at MIT in three years and get a master's in one year.
- DRDavid Rosenthal
Yeah, pretty, pretty smart. But it turns out that that freshman year grad seminar he took actually has a big impact on him because he doesn't do well in the class. He can't keep up, and Jim's pretty self-aware here. There are other people at MIT who never run into problems. [chuckles] They never hit a limit. They never struggle understanding any concept, and he realizes that, "Oh, I'm smart. I'm very, very smart. I'm smarter than most other people here, but I'm not one of those people."
- BGBen Gilbert
Right, which is... You know, what do you do with that information? You realize you have to add a few of your skills together to become the best at something. You have to be smart and something else.
- DRDavid Rosenthal
Yes. So Jim's own words on this are, "I was a good mathematician. I wasn't the greatest in the world, but I was pretty good." But he recognizes, like you said, Ben, that he has a different advantage that most of the super geniuses lacked, and that's that, as he put it, he had good taste. So these are his words: "Taste in science is very important. To distinguish what's a good problem and what's a problem that no one's gonna care about the answer to anyway, that's taste, and I think I have good taste."
- BGBen Gilbert
By the way, this is exactly the same thing as Jeff Bezos in college, realizing he wanted to be a theoretical physicist. He met some of the extreme brainpower people that would go on to become the best theoretical physicists in the world, and he said, "I'm smart, but I'm not that smart," and so switched to computer science.
- DRDavid Rosenthal
I think the analogy here is like sports. There are all-star players, there are Hall of Famers, and then there's LeBron and MJ, and Jim ends up being a Hall of Famer mathematician, but he's not Tom Brady.
- BGBen Gilbert
I mean, he's got a pretty important theorem named after him-
- DRDavid Rosenthal
... That goes on to become a foundation of string theory in physics, which isn't even Jim's field.
- BGBen Gilbert
Crazy.
- 13:26 – 17:44
First brush with markets: trading as a rush—and an early lesson
- DRDavid Rosenthal
Totally crazy. So after he's done at MIT, and after the road trip, [chuckles] Jim heads out to Berkeley in California so that he could do his PhD with the professor Shiing-Shen Chern, and much later in life, Jim would collaborate with Chern for the Chern-Simons theory that we talked about earlier, that becomes one of the foundational parts of string theory in physics. But before Jim leaves for the West Coast, he meets a girl in Boston, and they decide to get engaged in four days. [laughing] Uh, I mean, this is, this is him back then. These were the times. And when they get to California, and they get married, Jim takes the $5,000 wedding gift, that I believe they got from her parents, and he decides, "I wanna multiply this." So he starts driving from Berkeley into San Francisco every morning to go hang out at the Merrill Lynch brokerage office, and just be a rat hanging around the brokerage and find ways to trade and turn this money into something more.
- BGBen Gilbert
Which is so interesting to think about because, at that point in time, there was such an advantage to just being there. This wasn't even the trading floor, but information is all so manual and all so relationship-driven in the markets, that there was basically no way to be in on the action unless you were physically there in on the action.
- DRDavid Rosenthal
Exactly. Yeah, you couldn't just log into Yahoo Finance or something, or open the Stocks app on your iPhone, which even the information they were getting was God knows how long delayed from New York or from Chicago for the futures and commodities that are being traded that Jim gets into. He's as close to the action as he can possibly be, but he's a long, long way from the action.
- BGBen Gilbert
Yep.
- DRDavid Rosenthal
Nonetheless, when he starts out doing this, Jim hits a hot streak, and he goes up 50% in a few days.
- BGBen Gilbert
Trading is easy!
- DRDavid Rosenthal
Trading is easy. He says, "I was hooked. It was kind of a rush."
- BGBen Gilbert
I bet.
- DRDavid Rosenthal
Except he ends up losing all of his profits just as quickly. [chuckles]
- BGBen Gilbert
Yeah, important to learn that lesson early.
- DRDavid Rosenthal
Yes, and also right around this time, Barbara, his wife, gets pregnant with their first child, and is like, "You can't be driving into San Francisco every morning and gambling our future like this."
- BGBen Gilbert
Right, effectively playing the ponies.
- DRDavid Rosenthal
Yeah, exactly. So Jim's like, "Okay, okay, I'll stop. I'll focus on academia for now." So he finishes his PhD in two years. They come back to Boston, and he joins MIT as a junior professor at age 23. So they stay one year in Boston, but Jim, even though he's got a family, even though he's super successful as a young academic here, you know, he's got kids, he's restless. So one of his buddies from the scooter trip to Bogota is from Bogota and lives there, his family's there. He has an idea to start a flooring tile manufacturing company 'cause he's like, "You know, the flooring at MIT and in Boston, it's so much nicer than in Bogota. We should start a company and [chuckles] make the same kind of flooring here."
- BGBen Gilbert
When I read this, I couldn't believe that this was Jim Simons' first business venture. Like, it's so random, but it really is emblematic of just how much he was thrill-seeking and just looking for anything that was unexpected, different, exciting. He just gets bored fast.
- DRDavid Rosenthal
Totally. Uh, not just is this the start of his entrepreneurial career, the seeds of this financially are what go on to start RenTech.
- BGBen Gilbert
It's wild.
- DRDavid Rosenthal
Totally wild. So Jim takes a year off and [chuckles] goes down to Bogota.
- BGBen Gilbert
This is a guy with an MIT undergrad and master's, and a Berkeley PhD in theoretical math-
- DRDavid Rosenthal
Who's now a professor at MIT.
- BGBen Gilbert
Who is taking a year off to go work on a flooring company in Bogota.
- DRDavid Rosenthal
Yes, accurate. So he does that for a year, they get it set up, he gets bored again. He's like: All right, I don't wanna just run this company. I've helped set it up. I have an ownership stake in it now. He bounces back to Boston, this time to Harvard, as a professor there for a year.
- BGBen Gilbert
He's really racking them up.
- DRDavid Rosenthal
But he spends a year there, and he's like, "Ah, got the itch again," and, you know, the junior professor's salary isn't that much, and like we said about him back from his childhood days, he sees the appeal in being rich, and he's like: This is not a path to being rich. [laughing]
- BGBen Gilbert
[laughing]
- 17:44 – 27:44
Cold War codebreaking at IDA: the conceptual blueprint for quant trading
- DRDavid Rosenthal
So he's like, "I'm gonna go put my skills out on the open market." He gets a job in Princeton, New Jersey, not at Princeton University, but at the Institute for Defense Analyses, which is a nonprofit organization that consults exclusively for the US government, specifically the Defense Department, and specifically the NSA. [chuckles] These are the civilian code breakers.
- BGBen Gilbert
Yes, it was basically formed with this idea that, one, across various branches of our government, we need better collaboration and cross-funding of the same initiatives, and two, there are gonna be a lot of people who don't work for the government that we're gonna wanna hire to do some pretty secret work.
- DRDavid Rosenthal
... Yep. So the IDA there in Princeton kind of functioned like the Institute for Advanced Study, which is also in Princeton. That's where Einstein went when he came to America, kind of an independent think tank research group, except it's solely focused on code breaking and signal intelligence with the Russians during the Cold War.
- BGBen Gilbert
Yeah, it's a pretty wild charter, and especially how special of an organization it was. Like, the way these people would spend their time is part code breaking, but part kind of goofing around because the creativity of mathematicians working together on passion projects is important to discovering clever new algorithms.
- DRDavid Rosenthal
Yes, this is so, so key, and this culture ends up getting translated whole cloth right into RenTech. So the way IDA worked, and I assume still works to this day, is they recruited top mathematicians and academics to come be code breakers there. They would double their salaries-
- BGBen Gilbert
And importantly, it couldn't have been a government division if they were gonna be doing that because there's very specific congressionally approved budgets for payroll.
- DRDavid Rosenthal
Exactly. They figured out that they needed to attract the smartest people in the world who weren't gonna come just go work for the Department of Defense. This was the way to do it. So like you said, Ben, the charter of the group was that employees had to spend fifty percent of their time doing code breaking, but the other fifty percent of the time, they were free to do whatever they wanted, like research, pursue whatever they were doing in academia, publish papers. Kind of the appeal of going there was, "Hey, it's the same thing as being a professor at MIT or Princeton or Harvard or whatever, except you're doing code breaking instead of teaching, and there's no bureaucracy to worry about. There's no politics." It's just like, "Hey, you do your code breaking work, and then you publish it. You can collaborate with your colleagues there."
- BGBen Gilbert
Yep.
- DRDavid Rosenthal
Now, this is pretty crazy. Very quickly after Jim arrives at IDA, remember, he's in money-making mode at this point in time, he recruits a bunch of his very brilliant colleagues to come work with him in their fifty percent free time on an idea to apply the same work and technologies that they're using in code breaking and signal intelligence to trading in the stock market. So they come together, and they publish a paper called Probabilistic Models For and Prediction of Stock Market Behavior. And everything that they suggest in this paper really is RenTech, just twenty years before RenTech.
- BGBen Gilbert
It's crazy, 1964, this was published?
- DRDavid Rosenthal
Yes. Now, at this point in time, fundamental analysis was then, as in most of the world today still is, the primary way of investing in things. Of, "Hey, I know this company. I'm gonna analyze their revenues, their price multiple," or, "I'm gonna think about what's happening in the currency markets or in the commodity markets and why copper is moving here, or the British pound is moving there, and I'm going to invest on those insights."
- BGBen Gilbert
You're effectively looking at the intrinsic value of an asset, trying to assign it a value and make investments based on that.
- DRDavid Rosenthal
Yes, fundamental investing. There also existed, in the '60s, technical investing, which kind of is voodoo. [laughing]
- BGBen Gilbert
[laughing]
- DRDavid Rosenthal
This is like I'm looking at a stock chart, and I've got a feeling-
- BGBen Gilbert
[chuckles]
- DRDavid Rosenthal
... that it's gonna go up. Like, I'm tracing this pattern, and, like, it's going up, baby, or, "No, no, no, this pattern is going down."
- BGBen Gilbert
Yeah, using the phrase technical might be a little generous, but what they're looking for, basically trying to mine trading behavior for signal about the way that it will trade in the future rather than mining the intrinsic information about an asset for what you think it will do in the future.
- DRDavid Rosenthal
Right. And what Jim and his colleagues here are suggesting is that, but just not really done by humans. It's that with a lot more data and a lot more sophisticated signal processing.
- BGBen Gilbert
And importantly, you might say, why is it this group of people that came to that conclusion of applying computational signal analysis to investing? Well, it's effectively the same thing as code breaking. You are looking for signal in the noise and trying to use computers and algorithms to mine signal from something that otherwise kind of looks random.
- DRDavid Rosenthal
Totally. When Jim started working on code breaking, I think he just looked right back to his experience trading in the markets and was like: "Whoa, this is the same thing."
- BGBen Gilbert
Which is not an insight other people had. That was the amazing thing about his background priming him to realize that.
- DRDavid Rosenthal
Yes, there's all this noise in this data, and it is impossible for a human to sit here and look at this data and say, "Oh, I know what the Soviets are saying." No, no, you have to use mathematical models and statistical analysis to extract the patterns.
- BGBen Gilbert
So mathematical models, statistical analysis, we actually hear a lot of that in the world today because machine learning is a thing.
- DRDavid Rosenthal
Yes. What they are really doing here at IDA and then soon in RenTech is early machine learning, and Jim just had this incredibly brilliant insight that you can use these techniques and this technology for making investments, which makes this the perfect time to talk about our presenting sponsor for this season, J.P. Morgan Payments.
- BGBen Gilbert
Yes. The finance industry has a rich history of innovating, dating all the way back to the literal Renaissance, where double-entry bookkeeping and letters of credit revolutionized global trade and economic development, and J.P. Morgan Payments really continues that tradition in their technology investments today. They move ten trillion dollars a day securely. That is a quarter of all US dollar flows globally. Just think about the sheer volume of data at five thousand transactions per second and how important that is to the global economy.
- DRDavid Rosenthal
... Unsurprisingly, J.P. Morgan Payments has been in the AI game for years now. Similar to RenTech, they were also early to recognize the value of AI to gather, process, and analyze those massive troves of data to provide solutions for their customers and mitigate risk, like when they incorporated AI into their cash flow forecasting tool, which helps businesses manage liquidity, and that proved especially valuable during the pandemic.
- BGBen Gilbert
Yep. So also unsurprisingly, J.P. Morgan was ranked number one in a recent global banking index of AI capabilities, with Fortune saying they were, quote, "head and shoulders above the others." Their customers get AI-powered payment solutions for fraud prevention, customer insights, and treasury insights, all of which grows the bottom line. They can even analyze transaction data to predict and mitigate fraud patterns in real time with their validation services, helping stop millions of dollars for customers in attempted fraud.
- DRDavid Rosenthal
Yep. We were doing some research to prep for this segment, and we came across something pretty wild. The United States Treasury Department has started using AI to detect suspected check fraud and recovered over three hundred and seventy-five million dollars in 2023 utilizing the new tools. The US Treasury Department disperses trillions of dollars annually, so if they continue to employ new technologies like this, it could really add up to the tune of billions. So how does this fit in? Well, the Treasury Department recently selected J.P. Morgan to provide account validation services for federal agencies. Obviously, payment integrity and this issue of improper payments is top of mind for them and at enormous scale. So whether you are one of the largest institutions in the world or a small business like us here at Acquired, J.P. Morgan offers you peace of mind and protection.
- BGBen Gilbert
Yeah. One more playbook theme in common between RenTech and J.P. Morgan Payments, they both analyze data to uncover patterns and insights you may never think to look for. One of their clients, a furniture store, discovered a correlation with customers who also shop at pet stores, where shoppers spent seventy-six percent more than the average customer when this was the case. So the furniture store launched a line of pet-friendly furnishings for that audience. These are the sorts of insights that drive growth with J.P. Morgan Payments as your partner.
- 27:44 – 33:49
Hidden Markov models: early machine learning logic applied to markets
- DRDavid Rosenthal
Yep. So then the natural question is, okay, what is the model here? How are they gonna do this? And it turns out that one of the employees of IDA at this time, and one of the members of this sort of rebel group, shall we say, within the organization, is a guy named Lenny Baum, and Lenny just happens to be the world expert in a mathematical concept called a Markov model, specifically a version of Markov model called a hidden Markov model. Now, a Markov model is a statistical concept that's used to model pseudo-random or chaotic situations. Basically, it says: Let's abandon any attempt to actually understand what is going on in all of this data that we have, and instead, just focus on what are the observable states that we can see of the situation. Can we identify different states that the situation is in? And if we just do that, can we predict future states based on what we've observed about the patterns of past states? And the answer to that is usually yes, even if you don't know anything about fundamentally how the system operates.
- BGBen Gilbert
So the great example that Greg Zuckerman gives in the book is-
- DRDavid Rosenthal
Yes, a baseball game.
- BGBen Gilbert
There's three balls and two strikes. That state has a narrow set of states after it. It's gonna be a strikeout, they're gonna get on base, it's gonna be a walk, or maybe they foul it off, and it keeps going. There's only really a narrow set of things that could happen after that, whereas when it's zero balls and zero strikes, there's a lot that could happen. They could just keep pitching, and if you don't know the rules, you're like: Why do they just keep pitching? And so it's this sort of great way to explain this idea of the black box, that if nobody tells you the rules to the game, by observing the outputs enough and observing, okay, in this state, these outputs are possible, you actually can kind of get pretty good at at least, if not predicting, understanding the probability distribution of the outcomes for any given state in the game.
- DRDavid Rosenthal
So we brought up machine learning and AI a minute ago. This is a foundational concept to modern-day AI. If you think about large language models and predicting what comes next, it's not like these large language models necessarily understand English. They're just really, really good at predicting states and the next state, i.e., characters and the next character, or pixels and the next set of pixels or frame, et cetera.
- BGBen Gilbert
And obviously, they're much fancier than that, but that is kind of the underpinning of it all. I mean, I remember in my sophomore year of college computer science class, I had a Markov chain assignment, and it was basically write a Java program to ingest this public domain book, and then I would give it a seed word, you know, the first word of each sentence, and press Return, Return, Return, Return, Return. And it would scan through the probability tree and give me the most probable word based on the corpus of the book that it just read to create some sentence, and it feels like magic. And of course, in these early rudimentary Markov chain things like the one I did in college, it kind of spits out nonsense, but that would evolve to be the LLMs that we know of today.
- DRDavid Rosenthal
... Yes, totally. And that is what they were using at IDA to do code breaking, and that's what they propose in this paper that they could use in the stock market, too.
- BGBen Gilbert
Exactly. And the way that this applies to investing is just like you might not know the rules of baseball, but if you've watched enough baseball, you can kind of guess at what the probabilities of the next thing to happen are based on the state. Investing's kind of the same thing, or at least the stock market movements are, where you don't know the future, you don't know what's gonna happen. You don't know if stock X affects stock Y in some way, because you don't know in what way those companies do business together or who holds both stocks. Are they overlapping investors? Like, you don't know the relationship between those companies, so you can't forecast with a hundred percent certainty what is going to happen. However, if you suck in enough data about what has happened in the past and the probability distribution from every given state in the past, you probably could make some educated guesses, or at least understand the probability of any individual outcome based on a state today of what could happen next.
- DRDavid Rosenthal
Yes, exactly. So Jim and Lenny and this whole little crew, they're pretty fired up. They're like: "Oh, great. Let's go raise a fund and invest in the markets using this strategy."
- BGBen Gilbert
Certainly, we're gonna be successful at raising that fund, and certainly, we're gonna be very profitable because we've got this great idea.
- DRDavid Rosenthal
Totally! What could go wrong? Well, in the mid-'60s, the idea that some wonky academics at some random secretive agency in Princeton, New Jersey, could go raise money was non-viable. I mean, it was hard enough for Warren Buffett to raise money at this point in time for his fund, and he was Benjamin Graham's anointed, appointed disciple. And here are these academics who are working at some random, unknown nonprofit saying, "Give us money. We don't know anything about these companies [chuckles] that we're going to invest in. We don't know anything about fundamentals, but we've got a really good algorithm." People are probably like: "What is an algorithm?" So they just have no access to capital.
- BGBen Gilbert
Right, this was decades before it became high pedigree to come from a technical computer science background in the world of investing.
- DRDavid Rosenthal
Yes. So a bunch of kind of Keystone Cops-style fundraising happens here. They're going around in secret. They're trying to keep the IDA bosses from knowing what they're doing. One of the group ends up leaving a copy of the investment prospectus on the copy machine [laughing] at work one night, and the boss discovers it and calls them all into his office and is like: "Guys, what are you doing here?" [chuckles]
- BGBen Gilbert
Right. It's a little bit of a clown show on the operational side, even if the idea is good.
- 33:49 – 38:30
Vietnam War fallout: Simons is fired and lands at Stony Brook
- DRDavid Rosenthal
Yes. So they end up abandoning the effort, both because they can't raise money and because IDA has found out about this, and they're not too pleased. Shortly after all this, though, Jim ends up moving on anyway because the Vietnam War starts, and he, as you can imagine from his background, is not a supporter of the Vietnam War at this point in time. Jim writes an op-ed in The New York Times denouncing the Vietnam War and saying, like, yeah, he's, you know, sort of part of the Defense Department, but, like, not everybody in the Defense Department [chuckles] is for the war.
- BGBen Gilbert
Which is so naive, thinking you can write an op-ed in The New York freaking Times, and that's not gonna create issues for you in your job.
- DRDavid Rosenthal
Even more than that, amazingly, nobody really paid attention to it, except a reporter at Newsweek, who then comes to interview Jim and ask him some more questions, and he just doubles down on this. [chuckles] And when the Newsweek piece comes out, that's when the Department of Defense is like: "All right, you gotta fire this guy." [laughing]
- BGBen Gilbert
[chuckles] Yep.
- DRDavid Rosenthal
So Jim gets fired in 1967. Even though he's a star codebreaker, he made supposedly huge contributions to the group, which are still classified. But at age 30, with a wife and three kids, he's out on the street, and even though he's super smart, his colleagues love him, clearly, he's now bounced out of MIT, he's bounced out of Harvard, he's gone to this seemingly final home for him, great place at IDA. He gets bounced out of there, too. His job prospects are not great.
- BGBen Gilbert
Yeah.
- DRDavid Rosenthal
So he takes pretty much the only halfway decent paying job that he could get, which is to be the chair of the newly established, or maybe reestablished, math department at the State University of New York, Stony Brook, which is the Long Island campus of the State University of New York. This is not Harvard. This is not MIT.
- BGBen Gilbert
No, it is not.
- DRDavid Rosenthal
But it did have one very important thing going for it, which is why Jim ended up there, and that is that Nelson Rockefeller, who was then the governor of New York, had launched a campaign, a hundred million dollar campaign, to try and turn this Long Island campus of the State University of New York into a mathematical powerhouse, to become the Berkeley of the East. I sort of thought MIT was the Berkeley of the East already, but Rockefeller is waging a campaign that he wants Stony Brook to become a math and sciences powerhouse, and Jim is the key. He wouldn't be able to recruit somebody like Jim otherwise, but because he's now kind of tarnished his career, here's a, like, very talented mathematician that they can convince to come be chair of the department.
- BGBen Gilbert
Yep.
- DRDavid Rosenthal
So they basically give Jim an unlimited budget and leeway to go try and poach math professors from departments all over the country and the world and bring them there to Long Island. And part of how Jim goes and recruits folks is money, like the old, "Hey, I'll double your salary," line.... But the other part of it, too, is he's given such leeway, and Stony Brook is so different from the politics of an MIT or a Harvard or a Princeton. He says, "Hey, come here, I'll pay you more. But even more importantly, you can just focus on your research. You're not gonna have to deal with committees. You're not gonna have to do all this stuff. There is none of this stuff here." You might have to teach a little bit, but that's not even the point. Rockefeller doesn't want this necessarily to become a great teaching institution. He just wants to assemble talent there.
- BGBen Gilbert
Yep.
- DRDavid Rosenthal
And amazingly, it works. Jim starts getting a bunch of great talent, including James Ax, who is a superstar in algebra and number theory from Cornell, and he ends up at Stony Brook, recruiting and building one of the best math departments in the world.
- BGBen Gilbert
Amazing.
- DRDavid Rosenthal
Totally amazing. But in true Jim fashion, after a couple of years of this, and also his marriage with Barbara falling apart, he starts getting restless again. He decides that he wants to go on a sabbatical and go back to Berkeley and reunite with his old advisor there and go spend some time out on the coast in California. And this is where Chern and Simons end up collaborating and developing the Chern-Simons theory that ends up winning the highest award in geometry from the American Mathematical Society, and really kind of is Jim's personal mark on mathematics.
- BGBen Gilbert
Yep.
- 38:30 – 46:01
Leaving academia: Monemetrics and the first real trading shop
- DRDavid Rosenthal
Now, also, right around the same time, remember the Colombian Flooring Company? It gets acquired, and Jim and his buddies who are partners in it come into a good amount of money. And Jim is newly divorced, he's restless in academia, he has these ideas back from when he was at IDA about what you could do in the markets if you had capital. He starts trading again, and he gets more and more into it. Meanwhile, like we said, he's becoming disillusioned again and restless at academia, and in 1978, he leaves to focus full-time on trading, which is a huge shock to the academic community. Remember, he's assembled this superstar team there at Stony Brook. There's a quote in Greg's book from another mathematician at Cornell, "We looked down on him when he did this, like he had been corrupted and had sold his soul to the devil."
- BGBen Gilbert
Yeah, I mean, it was really viewed in the math community as anyone who's going to do investing is throwing away their talent, and it wasn't even that it was common the way that it sort of is today.
- DRDavid Rosenthal
Right. Jim was the first one, but the idea that you would leave to do anything commercial, you're doing a disservice to humanity.
- BGBen Gilbert
Yes, exactly. And leaving to do anything, sure, but leaving to do investing was almost just seen as dirty. Like it's this rich person's game that provides no value to society.
- DRDavid Rosenthal
Right. Yeah, I don't think it was that the rest of the math world was skeptical that it could work. They probably were like, "Oh, yeah, this could work," but they were like, " Ew!" [chuckles]
- BGBen Gilbert
Academics tend to be much more motivated by prestige than money, so I could totally see this, other people being like, "Oh, I could do that if I wanted, but I have this higher calling, and everyone respects me for this higher calling, and my currency is the papers I publish and the awards that I win, and that's what I want."
- DRDavid Rosenthal
Yep. Now, Stony Brook, we should say, too, like, it's a very nice place.
- BGBen Gilbert
Yes.
- DRDavid Rosenthal
But it's in the middle of Long Island on the North Shore. This is not the Hamptons. It's, like, the Long Island suburbs.
- BGBen Gilbert
Yep, the wooded Long Island suburbs.
- DRDavid Rosenthal
Yes, the wooded Long Island suburbs. Here's Jim in a strip mall next to a pizza joint, setting up his trading operation that he decides, very cleverly, to call Monemetrics, a combination of money and metrics or econometrics. And he recruits his old IDA buddy, original partner in crime on the trading idea, Lenny Baum, to come and join him. And this time, though, they have some capital from the sale of the flooring company.
- BGBen Gilbert
And how much did he make on that flooring sale?
- DRDavid Rosenthal
I think together with Jim, his partners, and whatever money Lenny put in, they had a little less than four million dollars in this initial capital.
- BGBen Gilbert
In 1978.
- DRDavid Rosenthal
Yep. Now, Jim also has another advantage at this point in time, which is he's right down the street from Stony Brook, and he's just recruited all of these superstar mathematicians. [chuckles]
- BGBen Gilbert
The table has been set.
- DRDavid Rosenthal
Yes, and those folks are more loyal to Jim than they are to Stony Brook.
- BGBen Gilbert
But they're more loyal right now to academia than they are to finance. This is not a paved pathway until Jim paves this pathway.
- DRDavid Rosenthal
Yes, in general, but some of them, and in particular, the superstar James Ax, Jim convinces to come join him in his trading operations.
- BGBen Gilbert
So having Baum and Ax and Simons, it's like suddenly this extremely credible team in the math world.
- DRDavid Rosenthal
Yes, beyond credible.
- BGBen Gilbert
Right. All the theorems that a lot of mathematicians are using every day are all named after these three guys who are now at the same firm trading.
- DRDavid Rosenthal
Yes, and it's led by Jim, who's somebody that they respect as an academic, but even more important, is somebody they want to work for and they look up to and they think is cool, and he's out there being like, "Hey, I think we can make money."
- BGBen Gilbert
Right.
- DRDavid Rosenthal
Now, at this point, they're primarily trading currencies, not stocks. And currencies are obviously large markets, but they aren't impacted by as many signals and as many factors as stocks are, or really even slightly more complex commodities like, I don't know, soybeans or whatever.
- BGBen Gilbert
And it seemed to me like a lot of the trading of currencies they were doing was basically based on feelings that they had around how a central bank was acting, like if the head of state of a certain country was gonna do something or not. It's basically like betting on how one single actor who was in control of currencies at governments would act.... So to your point about very few signals impacting price, it's knowing what one person is gonna do.
- DRDavid Rosenthal
Yes, and this is super important. At the end of the day, they build some models there. They're getting the early versions and infrastructure and scaffolding of this quantitative approach set up. But in terms of the actual trades they're putting on, they're still doing all of it by hand, and they're still all really going on a fundamental type analysis. They'll take some signals from the model, they'll see it's interesting what they spit out, but they're not gonna act on anything unless they can be like, "Oh yeah, I see what is going on here. I have a hypothesis."
- BGBen Gilbert
Right. The computers are by no means running loose at this point.
- DRDavid Rosenthal
By no means at all. Yeah, they're just suggesting patterns and ideas, and Jim, and Lenny, and James, they have to then decide, "Hey, are we gonna do this or not? Or are we gonna do something just totally different that we think is what's gonna happen?"
- BGBen Gilbert
Yep.
- 46:01 – 52:43
Renaissance Technologies is born as a bizarre hybrid: quant trading + venture capital
- DRDavid Rosenthal
Yes. And so much so that even Jim is ringleader here. He's far from convinced that he should put all of his wealth into this thing. [chuckles] He's like, "Oh, yeah, this is interesting. We're building, we're experimenting, like, great. But I also wanna put my money somewhere else, too, for some diversification." So this is where Howard Morgan comes in. You know, we used to talk about this on old Acquired episodes, that in the early days of Silicon Valley, there were only ten people [chuckles] out here, and they all knew each other, and they were all doing the same thing. This was also the case in East Coast finance, and technology, and early VC in these days. Howard Morgan would go on to be one of the co-founders of First Round Capital. [chuckles]
- BGBen Gilbert
Which was essentially spun out of Renaissance? Like, it was kind of the venture capital work that they were doing at Renaissance that didn't fit with the rest of Renaissance?
- DRDavid Rosenthal
Yes. So here's how it all went down, and this is so poorly understood out there.
- BGBen Gilbert
[chuckles] Yes.
- DRDavid Rosenthal
Howard was a computer science and business school professor at the University of Pennsylvania, so he taught CS at Penn and business at Wharton. And he had been involved in bringing ARPANET to Penn and was kind of like early, early Internet pioneer. And so as a result, he was super plugged into tech, and early startups, and really early, early proto-Internet stuff. And Jim gets excited about investing together with Howard. [chuckles] So they say, like, "Hey, maybe we should partner together." And in 1982, Jim actually winds down Monometrics, and he and Howard co-found a new firm together that's gonna reflect both of their backgrounds and be a great diversification. Jim and his group are gonna bring in the quantitative trading thing.
- BGBen Gilbert
And again, trading on currencies and commodities at this point.
- DRDavid Rosenthal
And Howard's gonna bring in private company technology investing, and they pick a name for a firm that is gonna reflect this: Renaissance Technologies.
- BGBen Gilbert
It's crazy!
- DRDavid Rosenthal
And that is why RenTech is called RenTech.
- BGBen Gilbert
I could not... When we figured this out in the research, I could not believe that this is not a more widely understood story, that this is the origins of what is today a fantastic venture capital firm, First Round Capital. But you could not name two more different strategies in investing. I mean, a long-term illiquid thing like venture capital, highly speculative, versus, you know, we're gonna trade whether we think the French franc is gonna go up or down tomorrow based on the whim of some government leader. It's unbelievable these were under the same roof.
- DRDavid Rosenthal
Totally. But when you know the whole background in history, it kind of makes sense because this is their personal money. This is Jim and his buddies, and Lenny, and James, and Howard. There's not institutional capital here. They're not out pitching LPs of like, "Oh, you should invest in my diversified strategy [chuckles] of currency trading and private technology startups."
- BGBen Gilbert
Yeah, when they say multi-strategy, this is really multi-strategy. [laughing]
- DRDavid Rosenthal
Yeah. [laughing] We'll get into what multi-strategy today means later. But in these early days of RenTech, fifty percent of the portfolio was venture capital, and fifty percent was currency trading.... And in fact, a couple years after they get started, the currency trading side of the firm almost blows up when Lenny goes super long on government bonds, and the market goes against him, and the whole portfolio drops forty percent, which is wild. That ends up triggering a clause in Lenny's agreement with Jim, and they sell off Lenny's entire portfolio, and he leaves the firm. This is crazy. I mean, blow-up risk is always an issue in the markets, but this happened to RenTec.
- BGBen Gilbert
And because we quickly got to this point in the story, it would be easy to say, "Well, that's a clause that has a lot of teeth." There were many sort of rumbles of something like this potentially happening. Simons going to Lenny and saying, "Hey, maybe we should cut some of our losses, and it's okay to trade out of these positions," and Lenny was just very dug in on, "I'm a true believer," and that's how you can get into a situation where you trigger a covenant like this.
- DRDavid Rosenthal
Totally, and again, also shows they weren't doing model-based quantitative trading really at this point in time.
- BGBen Gilbert
No, so much gut.
- DRDavid Rosenthal
So as a result of that, for a while, RenTec is truly almost entirely a venture capital firm. [chuckles] At one point on the venture side, just one investment, Franklin Dictionaries. Do you remember, Ben, the-
- BGBen Gilbert
Yes
- DRDavid Rosenthal
... Franklin Electronic Dictionaries? Yeah, that was one of their biggest investments. That one investment is half of Jim's net worth-
- BGBen Gilbert
What?
- DRDavid Rosenthal
- at this low point for the trading side. Yes.
- BGBen Gilbert
I had no idea. That's crazy.
- DRDavid Rosenthal
Yeah, so in the book, Greg talks about, "Oh, Jim was focused on venture capital," and that's kind of the story out there. It's like, well, he was focused on venture capital 'cause that was the only thing working and making money. [chuckles]
- BGBen Gilbert
Well, I mean, it's the only thing where they actually had an edge from Howard's access to deal flow 'cause they certainly didn't have an edge in the global currency markets.
- DRDavid Rosenthal
So I think perhaps in part because of the trading losses, James Ax starts to get a little disillusioned, too, and he tells Jim that he wants to move out to California with Sandor Straus, who started working with them at this point. Sandor was another Stony Brook alum that joined them, and the two of them want to move out to California and do trading out there. Jim says, "Sure, fine. I'm here with Howard. I'm doing venture capital stuff. Why don't you go move out to California? You can start your own firm," which they do. It's called Axcom, A-X-C-O-M, "And we'll contract with Axcom to run what's left of the trading operations here for RenTec."
- BGBen Gilbert
So it's this interesting arm's length thing, where Jim strikes a deal where he's gonna own a part of Axcom in exchange for this very favorable contractual relationship where they're gonna hire them to be the manager for this pot of money that Renaissance has raised, but, you know, it's technically not Renaissance. It's Axcom.
- DRDavid Rosenthal
Right. It's another company that is now doing [chuckles] the quantitative trading.
- BGBen Gilbert
Yep, and I think Jim owned a quarter of it. Is that right?
- DRDavid Rosenthal
Yes, that's right.
- BGBen Gilbert
And importantly, I don't think anyone had any idea what Axcom would become or how unbelievably profitable it would be.
- 52:43 – 57:41
Data engineering and bet sizing: the Axcom turning point
- DRDavid Rosenthal
No. So once Ax and Straus get out to California, Straus, he's kind of on the computing data infrastructure side. That's what he was doing at Stony Brook, and that's what he came into Renaissance to build. He starts getting really into data, and he starts collecting intraday pricing movements on securities. At this point in time, I think really the best data you could get from providers out there was maybe open and close data on securities pricing. Straus finds a way to get tick data, like every twenty minute data on these securities throughout the day.
- BGBen Gilbert
Not only that, he's getting historical data that predates what your traditional data providers would give you, and then ingesting it into computers and cleaning the data to get it into the same format as the tick data. So he's getting early 1900s, even 1800s stuff, to try to just say, "At some point, hopefully, we'll be able to make use of this, and I want to have this just really, really clean data set about the way that these markets interact."
- DRDavid Rosenthal
Yeah, I mean, he's doing ETL on the data [chuckles] -
- BGBen Gilbert
Yes
- DRDavid Rosenthal
... I think before anybody knew what ETL was.
- BGBen Gilbert
Again, no one told him to do that. That was just a self-motivated, almost like obsession of like, "Well, if we're gonna have data, it should be well-formatted and well-understood and labeled and all that."
- DRDavid Rosenthal
So that's one thing that happens. The other thing is Jim says, "Oh, you're going out to California. Let me hook you up with my buddy, who's a Berkeley professor out there, Elwyn Berlekamp," and Berlekamp had studied with folks like John Nash and Claude Shannon at MIT.
- BGBen Gilbert
I love that Claude Shannon is coming in again!
- DRDavid Rosenthal
I know.
- BGBen Gilbert
We talked about it a lot on the Qualcomm episode. Father of information theory, really the center of gravity for attracting tons of talent to MIT and kind of paving the way for what would become phone technology and telecommunications broadly in the future. But the fact that Berlekamp is crossing paths at MIT with Claude Shannon, so cool.
- DRDavid Rosenthal
So cool, and most importantly, for this specific use case, Berlekamp had worked with John Kelly, who developed the Kelly Criterion on bet sizing, which poker players will likely be well familiar with.
- BGBen Gilbert
Yep.
- DRDavid Rosenthal
So with this combination now of much, much, much better and deeper data from Straus and Berlekamp coming in and working with Ax on the models and saying, "Hey, we should be smart about the bet sizing that we're doing and the trades that are coming out of these models," versus I don't know what they were doing before. Maybe it was naive of, like, every trade was the same or just like, "We should actually be systematic about this."... the models start really working.
- BGBen Gilbert
Yep, this is the turning point.
- DRDavid Rosenthal
Yeah. In these kind of mid-'80s years, Axcom is generating IRRs of, like, twenty-plus percent on the trading side. You know, not necessarily gonna beat venture capital IRRs, but liquid-
- BGBen Gilbert
Yes.
- DRDavid Rosenthal
Reliable.
- BGBen Gilbert
Well, that's the thing. They don't know how reliable yet. They know they've done it kind of a few years in a row here, but the question is, how uncorrelated to the stock market over a long period of time, and how predictable are these returns? Or is it just super high variance?
- DRDavid Rosenthal
Yes, but the early results are really good, and Jim and Berlekamp especially are very encouraged by this. So in 1988, Jim and Howard Morgan decide to spin out the venture investments, and Howard goes to manage those with basically their own money. Fun coda on this: when Howard starts First Round a number of years later with Josh Kopelman, Jim, of course, is a large LP.
- BGBen Gilbert
Ah.
- DRDavid Rosenthal
And Howard, of course, remains an investor in RenTech. The first institutional fund that First Round ended up raising was a fifty X on a hundred and twenty-five million dollar fund. It had Roblox, Uber, and Square. So I believe this is right, I think Jim made as much money from his investments in First Round as Howard did from his LP stake-
- BGBen Gilbert
No
- DRDavid Rosenthal
... in RenTech.
- BGBen Gilbert
That's wild!
- DRDavid Rosenthal
Isn't that amazing?
- BGBen Gilbert
Wow, that is a untold story about Jim Simons. I think I read basically every primary source thing on Jim or Renaissance on the whole internet, but I assume you got that from Howard.
- DRDavid Rosenthal
Yeah, it was super fun talking to Howard about this, and just the history of how First Round started and early super angel investing and everything that became.
- BGBen Gilbert
I also didn't realize that First Round's Fund One was a fifty X on a hundred and twenty-five million dollar fund.
- DRDavid Rosenthal
First institutional fund, which I believe they called Fund Two.
- BGBen Gilbert
I mean, wild. Wild stuff.
- 57:41 – 1:10:35
Medallion Fund launches: early stumbles, then the machine starts working
- DRDavid Rosenthal
Totally wild. So when Howard spins out the venture activities, Jim then decides to set up a new fund as a joint venture between RenTech and Axcom, and they decide to name it after all of the collective mathematical awards that Jim and James and Berlekamp and all these prestigious mathematicians have won in their careers. They name it the Medallion Fund.
- BGBen Gilbert
Ba na na!
- DRDavid Rosenthal
Ba na na.
- BGBen Gilbert
And listeners, we've arrived. This is the part of the story that matters. The Medallion Fund is the crown jewel, or you might even say, actually, the only interesting thing about Renaissance, and it is born out of this observation that, "Oh, my God, what they're doing over there at Axcom is really interesting. Maybe they shouldn't be doing it all the way over there. [chuckles] Maybe that should be a deeper part of the fold here at RenTech, and we shouldn't have let that get away, or frankly, given up on the quantitative trading strategies too early." And again, still just currencies, still just commodities futures, not playing the stock market at all, but the seeds and the ideas, the huge amount of clean data, the robust engineering infrastructure to process all that data, the mining of signals from data to figure out what trading strategies to execute, that is really starting to form here in this new joint venture, this Medallion Fund.
- DRDavid Rosenthal
Those ideas had all existed before. This is the first time that it's all brought together-
- BGBen Gilbert
Yeah
- DRDavid Rosenthal
... and actually working and operationalized.
- BGBen Gilbert
And frankly, that computers got good enough to actually do it, too. That's another big piece of this.
- DRDavid Rosenthal
Yeah, I don't know that Strauss could have done his data engineering too much earlier in time.
- BGBen Gilbert
Yeah.
- DRDavid Rosenthal
But before we get into the just absolutely insane run [chuckles] that this Medallion Fund is about to go on, that continues right through to this day, now is the perfect time for another story about ServiceNow. ServiceNow is one of our big partners here in season fourteen and is just an incredible company.
- BGBen Gilbert
Yep. ServiceNow digitally transforms your enterprise, helping automate processes, improve service delivery, and increase operational efficiency, all in one intelligent platform. Over eighty-five percent of the Fortune five hundred runs on them, and they have quickly joined the Microsofts and the Nvidias as one of the most important enterprise software companies in the world today.
- DRDavid Rosenthal
So we talked on our Novo Nordisk episode about how ServiceNow founder Fred Luddy discovered this core insight that software can transform and eliminate manual tasks. And on Hermes, we told the story of how current CEO Bill McDermott came in and turbocharged that into an absolute monster, hundred and fifty billion market cap global behemoth. The key thread that connects those two eras is that from day one, Fred knew the ServiceNow platform could be used across the whole enterprise. But at the same time, he also knew from his decades of prior software experience that launching a broad horizontal offering right out of the gate as a startup was a recipe for failure. You need to start with a specific vertical use case, and in this case, he chose IT service management.
- BGBen Gilbert
Yep, and that's been true for us here on Acquired, too. David, if we didn't name it Acquired and cover technology acquisitions that actually went well, we never could have broadened and become the podcast that tells the stories of great companies. You can't just start as that.
- DRDavid Rosenthal
Totally.
- BGBen Gilbert
Well, this is what's so cool and where I think the playbook lesson really is for listeners. Because you can't just pick any use case, you have to be strategic about it, and IT was the perfect vertical because every other department has to interface with them, from the CEO on down. So they're gonna notice when IT service management rapidly improves. All of those support tickets that used to take forever are now just magically resolved.... and that greases the wheels for the other departments to say, "Hey, maybe we should adopt ServiceNow to turbocharge and digitally transform our service levels, too."
- DRDavid Rosenthal
Yep. Once those other departments do pull the trigger on joining the ServiceNow platform, who is in charge of rolling it out for them? Of course, it's IT- [chuckles] ... who are already true ServiceNow believers. I'm honestly not sure that there's a better enterprise software playbook in history than ServiceNow's. So once they established the beachhead in IT, they then took the same platform to HR with employee experience, they took it to CSM with customer service requests, they took it to finance with regulatory reporting, audit, and expense approvals, and now they're adding AI, which will take everything to the next level.
- BGBen Gilbert
Yep. So if you want to learn more about the ServiceNow platform and playbook and hear how it can transform your business, head on over to servicenow.com/acquired, and when you get in touch, just tell them that Ben and David sent you.
- DRDavid Rosenthal
So they've got this grand new plan and vision with the Medallion Fund. Unfortunately, right out of the gate, the fund stumbles a bit, and Ax ends up getting burned out. Berlekamp, though, is like, "No, no, no, no, this is an anomaly. Like, we're gonna fix this. I really, really believe that what we're doing with these models is gonna be extremely profitable." So he buys out most of Ax's stake in the summer of 1989, and he moves the offices up to Berkeley, and there he comes up with the idea that, hey, we should trade more frequently, a lot more frequently. Because if what we're trying to do is understand the state of the market from the data we have and then predict the future state of the market and then combine that with figuring out the right bet sizing to make, we actually want to make a lot more trades to get a lot more data points and learn a lot more about the bets we're making so that we can then size them up or size them down.
- BGBen Gilbert
It's that, and it's two other things. One is the further into the future you look, the less certain you can be about it. If you know something is worth $10 right now, what you know five minutes from now is it's probably gonna be worth about $10. The most likely situation is it's within five percent of that. If you ask me three years from now, I have almost no intuition about that, and a state machine is the same way. If you flash forward a whole bunch of states, you sort of lose predictability as you sort of continue down that chain. The second thing is, if your models are showing that you're gonna be right, call it something like fifty point two five percent of the time, then the amount of money you can make is gated by the number of bets you can make at a quarter percent edge. If I walk up to the casino, and I think I'm right about this particular roulette wheel, which of course you're not, fifty point two five percent of the time, and I decide to play once or play twice or play five times, there's a chance I could lose all my money, or if I have tiny little bet sizes, then I'm just not going to make that much money. But if I walk up to said game with a little bit of edge, and I use small bet sizes, and I play ten thousand times, I'm gonna walk out with a lot of money.
- DRDavid Rosenthal
There is a great Bob Mercer quote about this later. He says, "We're right fifty point seven five percent of the time."
- BGBen Gilbert
And I do think he's making up that number. I think it's illustrative.
- DRDavid Rosenthal
Right. "But we're one hundred percent right- [chuckles] ... fifty point seven five percent of the time." You can make billions that way. [chuckles]
- BGBen Gilbert
It's so true. When you have that little edge, it's about making sure that you're not betting so much that a few bets that don't break your way can take you down to zero, and to make sure you can just play the game a lot.
- DRDavid Rosenthal
A lot, yes. And then back to the Kelly Criterion, adjust your bet sizes over time as you're making those bets.
- BGBen Gilbert
Yep. Now, of course, this is all great in the abstract if it's that you're literally sitting at a casino, and you're somehow perfectly making these bets, and you're just sitting right there at the table, and then you can walk over to the cashier. It gets a little bit different in the market. For example, there are real transaction costs, especially at this point in history, before some of these more, uh, innovative trading business models with pay for order flow and zero transaction fees and all this stuff. There's real transaction costs to putting on these trades, and of course, you're gonna move the market when you put on these trades.
- DRDavid Rosenthal
Yes, this is slippage.
- BGBen Gilbert
There's all sorts of practical consideration. You could get front-run by other people. It's not just a computer program that gets executed. You actually have to meet the constraints of the real world when you're deciding, instead of a few big bets, we're gonna have a hundred thousand tiny bets.
- DRDavid Rosenthal
Yes, and as time goes on, and the whole quant industry emerges and becomes much more sophisticated, I think it's particularly the slippage there that becomes the governor on how high velocity you can actually be on this, and the slippage is that once you are at a certain scale, you are gonna move the market with your trades.
- BGBen Gilbert
So the deeper you get into the order book, like, let's say you want to buy five million dollars of something, maybe your first hundred thousand dollars, you're pretty sure you can get the quoted price. But buy your last hundred thousand dollars of that five million dollar buy, the price might have gotten pretty different already.
- 1:10:35 – 1:17:10
From success to dominance: buyouts, centralization, and closing the fund
- DRDavid Rosenthal
So at the end of 1990, Simons is so jazzed about what's going on that he tells Berlekamp, "Hey, you should move here to Long Island. Let's recentralize everything here. I wanna go all in on this. I think with some tweaks, we can be up eighty percent after fees next year." Berlekamp is a little more circumspect. A, he wants to stay in Berkeley. He doesn't have any desire to move to Long Island. And B, I couldn't tell how much of this is just he's a little more conservative than Jim, or how much of this actually might be his, hey, whole poker bet sizing thing. He turns to Jim, and he says, "Well, if you're so optimistic, why don't you buy me out?" So Jim does, at six X the basis that Berlekamp had paid Ax a year earlier.
- BGBen Gilbert
On the one hand, making a six X in one year sounds great.
- DRDavid Rosenthal
On the other hand, [chuckles] this is the equivalent of when Don Valentine sold Sequoia's Apple stake before the IPO to lock in a great gain, but miss out on all the upside to come.
- BGBen Gilbert
David, I think we should throw this out so people understand the volume of this. They've generated on the order of sixty billion dollars of performance fees for the owners of the fund over their entire lifetime. So on the one hand, six X in a year ain't bad. On the other hand, you owned a giant part of something that has dividended sixty billion dollars in cash out to its owners. Oof!
- DRDavid Rosenthal
Yeah. That's just on the carry side. I mean, the owners are the principals, so just like dollars out of the firm, it's probably twice that. I would estimate probably a hundred and fifty, two hundred billion dollars that have come out of Medallion over the last thirty-five years. So Jim buys out Berlekamp. He rolls everything in the Medallion Fund back into RenTech itself, moves everything back to Stony Brook. Strauss moves to Stony Brook.
- BGBen Gilbert
So it's now the Jim Simons Show in New York, with Strauss building the engineering systems, and Ax, I think, still had a small stake.
- DRDavid Rosenthal
Yes, that's right, and Strauss had a stake as well. So once Jim takes control and moves everything back, he basically decides that he's gonna turn RenTech into an even better, even more idealized version of IDA and the math department at Stony Brook. He's gonna make this an academics paradise, where if you are one of the absolute smartest mathematicians or systems engineers in the world, this is where you wanna be. So of course, he starts raiding the Stony Brook [chuckles] department itself again, and this is when Henry Laufer joins full-time.... Laufer had been consulting with Medallion in the early days and working with Berlekamp as they're doing bet sizing, as they're making more frequent trades. But now, once the whole operation is moved back to Long Island, Laufer's like: "Oh, okay, great, I'll come full time. I'm here at Stony Brook anyway. This is way more fun than teaching."
- BGBen Gilbert
And listeners, I imagine this is probably the point where you're starting to get confused and saying, "There are so many people in this story." I think we're on eight or nine. We just keep introducing more people, and that is the story of Renaissance. It is not this singular, clean narrative. It is a very complex reality of a whole bunch of different people that came in and out at different eras, where the firm was trying different things and eventually became phenomenally successful with a very particular approach. But while they were figuring it out along the way, it took a lot of people.
- DRDavid Rosenthal
A lot of people, and just a lot of time, too. This is twenty-five years. This is a quarter century from the time that Baum and Simons write the paper at IDA until Medallion really starts to work. It takes a long time.
- BGBen Gilbert
And we haven't even introduced the two people who would become the co-CEOs of this company-
- DRDavid Rosenthal
[laughing]
- BGBen Gilbert
-for twenty years.
- DRDavid Rosenthal
Yes. Well, let's get to that. [chuckles] So Jim moves everything back to Long Island, sets it up as this academic paradise. He's recruiting the smartest people in the world. In 1991, the next year, the firm does fifty-four point three percent gross returns and thirty-nine point four percent net returns after fees. So not Jim's bogey of eighty percent, but still pretty freaking great.
- BGBen Gilbert
And we should say, the years of modest performance are behind them. From every single year forward, they shoot the lights out. From 1990 onward, they never lose money, and on a gross basis, they never even do less than thirty percent. It's working. It's going. The whole rest of the story is about, "Hold on, keep the machine working, and we're on the train."
- DRDavid Rosenthal
The historic run has begun, [chuckles] let's just say.
- BGBen Gilbert
Yep.
- DRDavid Rosenthal
So 1992, gross returns are forty-seven percent. 'Ninety-three, they're fifty-four percent. At the end of 1993, Simons decides to close the fund and not allow new LPs in. So if you're an existing LP, you can stay in, but they're no longer open for new inflows. He has so much confidence in what they're doing, that he thinks they're all gonna make more money without accepting new capital, by just keeping it to the existing investor base. 1994, gross returns are ninety-three freaking percent. Medallion, at this point, is stacking up cash. It is a meaningful fund. It's about two hundred and fifty million dollars total at this point in time, which is small, but we're talking about 1994 with a bunch of outsiders and academics that have managed to amass a quarter billion dollars here. People start to pay attention.
- BGBen Gilbert
And the performance fees on this are seven million dollars, thirteen million dollars, fifty-two million dollars. The free cash flow flowing to partners here is certainly becoming real, too.
- 1:17:10 – 1:32:12
Scaling problem and the equities leap: IBM speech-recognition talent changes everything
- DRDavid Rosenthal
Yes. But as they get into that, call it on the order of magnitude of a billion dollar scale, they start bumping into the moving markets problem and the slippage that we were talking about earlier.
- BGBen Gilbert
Yep, and that's sort of in the mid-nineties?
- DRDavid Rosenthal
Yep. As they're hitting this two hundred and fifty million, half a billion dollar scale.
- BGBen Gilbert
Right, the computer model spits out, "We should go buy this huge amount of something at this price." They go to do it, they can only buy ten, twenty, thirty percent of the amount they want at that price, and then suddenly, the price is very different.
- DRDavid Rosenthal
Yep. Up to this point, the vast majority of what Medallion is doing is trading currencies and commodities, not equities. 'Cause you might be thinking, "Okay, yeah, I hear you, the nineties was a different era, but half a billion dollar fund doesn't sound that big. How are they moving markets with half a billion dollars?"
- BGBen Gilbert
It's not the equity markets.
- DRDavid Rosenthal
It's because they're in these thinner markets. It's not that commodities and futures are small markets. They're large, but they're thin compared to equities. There's just not that much volume, and you just can't trade that much without slippage becoming a huge issue, and Medallion is now hitting that limit. So Simons decides, "The only thing we can do here to expand, which I'm such a believer in what we're doing, we need to expand, is we need to move into equities. Equities are the holy grail. If we can make this work there, the depth in those markets will let us scale way, way, way bigger than we are now, and there's so much more data about equities pricing that we can feed into our models, and the signal processing that we can do and the signals that we can find are gonna be even better."
- BGBen Gilbert
Right. There's so many buyers and sellers every day showing up to trade so many different companies at such high velocity, it's almost this honeypot for Renaissance's systems. This is sort of their moment. This is what they were built for, and it's kind of funny that they've just been in kid glove land the whole time with these thinly traded markets with minimal data.
- DRDavid Rosenthal
Yes, and this brings us to Peter Brown and Bob Mercer. And in 1993, one of the mathematicians that Jim had recruited to RenTech, a guy named Nick Patterson, gets especially passionate about going out and recruiting new talent, along with Jim. And this is, I think, one of the keys to RenTech and the culture there. People want other smart people to come be there, too. Nick's sitting there like, "This is a joy. I want to go find other best people in the world to hang out with."... And he had read in the newspaper that IBM was going through cost-cutting and was about to do layoffs. And he also knew that the speech recognition group at IBM had some absolutely fantastic mathematical talent. And really, what they were doing was, again, another vector in the early AI machine learning research. Specifically, IBM's Deep Blue chess project [chuckles] of the time had come out of this group, and Peter Brown there was the one that actually spearheaded the project.
- BGBen Gilbert
Yep. And it's interesting that you talk about speech recognition as the perfect fit for what they were doing, and you might say: Why is that? Well, the actual work that goes into speech recognition, natural language processing, is kind of the same signal processing that Renaissance is doing to analyze the market.
- DRDavid Rosenthal
It's not just kind of, it's exactly the same signal processing. [chuckles]
- BGBen Gilbert
Right. Speech recognition is a hidden Markov process, where the computer that's listening to the sounds to try to turn it into language doesn't actually know English, right? Obviously. But what it does know is, when I hear this set of frequencies and tonalities and sounds, there's a limited set of likely things that could come after it. And in Greg's book, he greatly points out this perfect example: when I say apple, you might say pie. The probability that pie is gonna be the next word following apple is significantly higher. And so these people who have spent their careers not only doing the math and the theoretical computer science behind speech recognition to help figure out and predict the next words, that you have a narrow set of likely words to choose from, so when you're listening to those frequencies, you can say, "It's probably gonna be one of these three," rather than search the entire dictionary for any word that it could be, to narrow the processing power. It's not only the theoretical side, but it's also people who have built those systems at IBM, like a real operational computer company.
- DRDavid Rosenthal
Yes, at operational scale, and this is what's so important and why the two of them become probably the most critical hires in RenTech's history, even including all the great academics that came before them. Because they're good on the math side, but they have this large systems experience. And Jim and Nick know that if they're gonna move into equities, because of the volume of data and because of how much more complex that market is, they need more complex systems, and the current talent at RenTech coming from academia has just never experienced that or built anything like it.
- BGBen Gilbert
And the world that they're entering is just exploding in complexity and dimensionality. And when I say that, here's what I mean: the data that they are mining, that they're looking for, is this intraday tick data between every stock trading. So they're in this sort of trying to map the relationship between one stock and every other stock, not just at that moment in time, but every time before it and every time after it. They're also, once they do identify patterns, which this is key, the algorithms identify the patterns. It's not a human with a hunch saying, "I think when oil prices go up, the airline prices are gonna get hit." It's computers doing machine learning to discover the patterns in the data. Then there's the second piece of, well, what trades do you actually put on to be profitable from the probabilities that you just discovered? All these weights of relationships between all of these different companies. You're not just putting on one trade, you're putting on ten, a hundred, thousands of simultaneous trades, both to hedge, to be able to isolate some particular variable that you're looking for, again, not you, but a computer is looking for, and you also need to do it in such specific bite sizes so that you don't move the market. So you're looking for a super multivariate, multidimensional problem, both on the data ingestion side and on the how do I actually react to it side. And all of this computation can't take a long time because you must act, you know, not in milliseconds. It's not a high-frequency trading that's front-running the market. That's not actually what they do. A lot of people think it is, but we'll get to that later. But they do need to act with reasonable quickness, probably on the order of minutes, so these need to be really efficient computer systems, too.
- DRDavid Rosenthal
Yeah. And the universe of equities is so much more multidimensional and interrelated. There are only so many currencies in the world, and there are especially only so many currencies that are large enough trading markets that you can operate in. There's not infinite, but thousands and thousands of equities in the world that are deep enough markets that you can operate in, and to some degree, they're all correlated with one another.
- BGBen Gilbert
And just keep adding layers of complexity here, keep adding new things to multiply by. Many of these are traded on multiple exchanges, so you might also be looking for pricing disparities on the same equity on different markets at different points in time. So there's just dimensions upon dimensions of things to analyze, correlate, and act upon.
- DRDavid Rosenthal
So Patterson and Simons go raid IBM. [chuckles] They're like Steve Jobs raiding Xerox PARC. They bring Peter and Bob and one of their programming colleagues, David Magerman, over from IBM into RenTech, and they get started on building the equities model. But it turns out, A, they're obviously very successful at that, but the impact that they have and what they build is even bigger because Bob and Peter realize that, hey, actually, we should just have one model for everything here: for currencies, for commodities, for equities. Everything is correlated. Everything is a signal. It's not like the equities market is wholly independent and separate from what's happening in currencies or what's happening in commodities. There are relationships-... everywhere. We really want just one model. This is like a fantastical undertaking, especially in the early to mid-'90s.
- BGBen Gilbert
Right. But if you can nail it, it means that you can do interesting things like, "Hey, we don't have a lot of data on this particular market, but it looks a lot like something we do have data on. So if it's all part of the same model, we can kind of just apply all the learnings from this other thing onto this brand-new thing that we're out looking at with little data for the first time. And because we're putting it all in one model and no one else in the world is, we can discover patterns that no one else knows about."
- DRDavid Rosenthal
It turns out that this was actually the second most important innovation that Bob and Peter bring to RenTech, the actual product and performance of having one model. The most important thing is that if you have only one model, one infrastructure, everybody in the firm is working on that same model. You can all collaborate all together, which is especially important when you have the smartest people in the entire world all in one building. Before this, there were separate models within RenTech, so insights and innovations and work that one team was doing on one model wouldn't get applied or translate over to work that was happening by another team on another model.
- BGBen Gilbert
They did have the cultural element, where it was encouraged that you share your learnings, but someone would have to take the time during their lunch break and go learn from you about those and then implement it in their version. There's a lag, and it may actually not get implemented.
- DRDavid Rosenthal
Yeah. This is wholly unique and revolutionary. No other at-scale investment firm, period, and especially quant firm, operates this way today with just one model. There are portfolio managers and teams and multi-strategy. People are culturally competitive with one another, but even if they're not, the work that you're doing on this side of Citadel is not impacting the work that you're doing on that side of Citadel.
- BGBen Gilbert
Right.
- DRDavid Rosenthal
What Bob and Peter do is they unify everything at RenTech, so all the wood is going behind one arrow.
- BGBen Gilbert
Yes. And before we talk about the impact of that, we wanna thank our longtime friend of the show, Vanta, the leading trust management platform. Vanta, of course, automates your security reviews and compliance efforts, so frameworks like SOC 2, ISO 27001, GDPR, and HIPAA compliance and monitoring, which is quite topical if you are in the heavily regulated finance industry and you need a lot of security and compliance. Vanta takes care of these otherwise incredibly time and resource-draining efforts for your organization and makes them fast and simple.
- DRDavid Rosenthal
Yeah, Vanta is the perfect example of the quote that we talk about all the time here on Acquired, Jeff Bezos, his idea that a company should only focus on what actually makes your beer taste better, i.e., spend your time and resources only on what's actually gonna move the needle for your product and your customers and outsource everything else that doesn't. In RenTech's case, this would be the model. Every company needs compliance and trust with their vendors and customers. It plays a major role in enabling revenue because customers and partners demand it, but yet it adds zero flavor to your actual product.
- BGBen Gilbert
Vanta takes care of all of it for you. No more spreadsheets, no fragmented tools, no manual reviews to cobble together your security and compliance requirements. It is one single software pane of glass, just like one model, that connects to all of your services via APIs and eliminates countless hours of work for your organization. There are now AI capabilities to make this even more powerful, and they even integrate with over three hundred external tools. Plus, they let customers build private integrations with their internal systems.
- DRDavid Rosenthal
And perhaps most importantly, your security reviews are now real-time instead of static, so you can monitor and share with your customers and partners to give them added confidence.
- BGBen Gilbert
So whether you're a startup or a large enterprise and your company is ready to automate compliance and streamline security reviews, like Vanta's seven thousand customers around the globe, and go back to making your beer taste better, head on over to vanta.com/acquired and just tell them that Ben and David sent you. And thanks to friend of the show, Christina, Vanta's CEO, all Acquired listeners get a thousand dollars of free credit, vanta.com/acquired. So David, the equities machine.
- DRDavid Rosenthal
Yes, and indeed, a machine it is. So Peter and Bob come in in 1993. In 1994, 1995, they're building this. RenTech is getting into equities.
- BGBen Gilbert
And yet, just imagine the computers that you were using during 1994 and 1995. It is astonishing, the level of computational complexity and coordination and results that they are pulling off, again, in real time, analyzing these markets with the technology that was available during those years.
- 1:32:12 – 1:52:57
Peak performance and the end of outside investors: Sharpe ratios, fee hikes, and capacity limits
- DRDavid Rosenthal
Yes, and then in the year 2000-... they just totally blow the doors off. One hundred and twenty-eight percent gross returns, net returns after fees of ninety-eight point five percent. This is bananas!
- BGBen Gilbert
They grow the fund from one point nine billion to three point eight billion of assets under management, again, purely by investing gains, not by getting any new investors, the year the tech bubble burst.
- DRDavid Rosenthal
Yes. While the whole rest of the market is down big time, Medallion is up [chuckles] a hundred and twenty-eight percent gross on the year. And this becomes a theme: high volatility is when Medallion really shines.
- BGBen Gilbert
And here you go, uncorrelated. They have their final stamp of approval right here of, not only are we a money-printing machine, we are a money-printing machine in all environments, regardless of the state of the broad market. And David, as you said, volatility actually makes their algorithms work even better, 'cause what are they doing? They're looking for scenarios where the market's gonna act erratically, and they can take advantage of people making decisions that they shouldn't. And any time any investors are under pressure, there's a little bit of edge that's gonna accrue to a Medallion that's saying, "Oh, okay, you're fear-selling right now? Well, I can determine if you should be fear-selling or not, and if I determine that you shouldn't be dumping that asset, I'm buying it from you."
- DRDavid Rosenthal
So there's a really fun story around this that really illustrates Jim's genius in managing the firm and the people, and how this year was when they really figured this out. So the first couple days of the tech bubble bursting, Medallion actually takes a bunch of large losses, and part of it might be that the model wasn't tuned right yet because nobody at RenTec had seen this type of behavior in the market before. Part of it might also be, too, that it didn't perform well for those couple days. It's a really stressful time for everybody. You know, everybody's in Jim's office. Jim's smoking his cigarettes.
- BGBen Gilbert
[laughs]
- DRDavid Rosenthal
It's a cloud of smoke, and they're debating what to do, and Jim makes the call to take some risk off. He's worried about blowing up. We're not very far removed at this point from Long-Term Capital Management. Uh, the model may be saying we should stay long here, but let's not blow up the firm.
- BGBen Gilbert
Yep.
- DRDavid Rosenthal
After this goes down, Peter Brown comes to Jim and offers to resign, given the losses that they incurred over these couple days, and Jim says, "What are you talking about? Of course, you shouldn't resign. You are way more valuable to the firm now that you've lived through this, and you now know not to one hundred percent trust the model in all situations."
- BGBen Gilbert
It's fascinating. It's such a good insight. That illustrates Jim as a leader right there.
- DRDavid Rosenthal
It totally does. There's a parallel story when Jim ultimately does retire in 2009, and Peter and Bob take over as co-CEOs, where a year or so before, the, quote-unquote, "quant quake" had happened, where similar to the tech bubble bursting, there was all of a sudden very large drawdowns among all quantitative firms in the market, and RenTec gets hit. And during that period, Peter argued very strenuously that we should trust the model, stay risk on. This is gonna be an incredibly profitable time for us. And Jim pumped the brakes and stepped in, intervened, and took risk off. And Peter goes to Jim again around the CEO transition and says, "Hey, Jim, aren't you worried that with me running the place now, I'm gonna be too aggressive and blow it up one of these days?" And Jim says, "No, I'm not worried at all. I know you were only so aggressive in that moment because I was there pushing back on you, and when you're in the seat, you're gonna be less aggressive." [chuckles] He's just such a master at insight into human behavior.
- BGBen Gilbert
It is so true, though. I even find this about myself, that I will naturally take the position of the foil to the person across from me. So if somebody's being pushy in some way, I'll find myself taking a position where if I r- pause and reflect, I'm like, "I don't think I expected to take this position coming into this conversation." But, you know, you naturally want to sort of play the other side to balance out the person sitting across from you.
- DRDavid Rosenthal
Yep. So back to the year 2000 and this incredible performance. Ben, to what you were saying earlier about uncorrelated returns, not only do they shoot the lights out that year, they're doing it when the market is down. We gotta introduce this concept of a Sharpe ratio now, which for all of you listeners that are in the finance world, you'll know this, but for everybody else, this is a really important concept.
- BGBen Gilbert
And I think people grasp it intuitively. We've mentioned this concept a couple times this episode, where, okay, great, it's amazing to have a fund that twenty-five X's or a year where you have a hundred percent investment return, or, "I bought Bitcoin yesterday, and it doubled overnight." Does that make you one of the best investors in the world? We all intuitively know, no, it doesn't, because maybe that was a fluke. Maybe you're taking on an extreme amount of risk, and then the question is always, adjusting for the risk that you're taking, can you produce a superior return, taking the risk into that account? And so you basically can provide value to investors as a fund manager in two ways: you can outperform the market, or you can be entirely uncorrelated with the market and get market returns. Or what you can do, as RenTec, is both. You can [chuckles] be uncorrelated and massively outperform, which is effectively the holy grail of money management.
- DRDavid Rosenthal
Yes, and so the Sharpe ratio is a measurement combining these two concepts.
- BGBen Gilbert
Exactly. So it's named after the economist William F. Sharpe. It was pioneered in 1966. It is effectively the measure of a fund's performance relative to the risk-free rate. So if you performed at fifteen percent that year and the risk-free rate was three percent, then, you know, your numerator is gonna be twelve percent, and it is compared against the volatility, or the standard deviation is technically what it is, but effectively...... how volatile have you been the last X years? And typically, it's looked at as a three-year Sharpe or a five-year Sharpe or a ten-year Sharpe. The Sharpe ratio represents the additional amount of return that an investor receives per unit of an increase in risk. And so David, you're starting to throw out numbers. Low Sharpe ratios are bad, negative Sharpe ratios are worse, 'cause that means you're underperforming the risk-free rate. High Sharpe ratios are good, 'cause it means that you're producing lots of returns, and your variance or your standard deviation or your sort of risk is low. So in 1990, they had a Sharpe of two point oh, which was twice that of the S&P 500 benchmark. Awesome.
- DRDavid Rosenthal
Yep. Good.
- BGBen Gilbert
Nineteen ninety-five to two thousand, Sharpe ratio of two point five, really starting to hum. Pretty unbelievable.
- DRDavid Rosenthal
Good. Where do I sign up to invest?
- BGBen Gilbert
At some point, they added foreign markets and achieved a Sharpe ratio of six point three, which is double the best quant firms. This is a firm that has almost no chance of losing money, at least historically, and massively outperforms the market on an uncorrelated basis.
- DRDavid Rosenthal
And I believe, if I have my research right, in 2004, they actually achieved a Sharpe ratio of seven point five.
- BGBen Gilbert
Astonishing.
- DRDavid Rosenthal
You know, again, back to our sports analogy here, these aren't Hall of Fame numbers. These are like, I don't know, make Tom Brady look like a third stringer.
- BGBen Gilbert
Yes, exactly.
- DRDavid Rosenthal
So on the back of 2000 and this rise, the next year in 2001, they raise the carried interest on the fund to thirty-six percent, up from either twenty or twenty-five percent, whatever it was before. Now, remember, they've already closed the fund to new investors, so there's still outside investors in the fund, but no new investors are coming in. And then the next year, in 2002, they raise the carry to forty-four percent. I mean, great work if you can get it, but for context, the Sequoias, the benchmarks out there, they have obscene carry of thirty percent. Forty-four is unprecedented.
- BGBen Gilbert
There's two interesting ways to look at this. One, they're just trying to jack it up so high that they just purge their existing investors out, where they're saying, "We're not gonna kick anyone out yet, but we've been closed to new business for a long time now. You should see yourself out at some point." The other way to look at this, which I think is probably the right way to look at it, is investors are arbitragers. They see a mispricing, they come into the market, they fix that mispricing. So anytime that there's an opportunity to bring the way that a currency is trading on two different exchanges closer together, investors are serving their purpose of coming in, arbitraging that difference, taking a little bit of profit as a thank you, and then sort of fixing the market to make the market a true weighing machine, not a voting machine, but making it so that all prices reflect the value of what something is actually worth. And in some ways, that's what Renaissance is doing here to themselves or to their investors. They're coming in and saying, "Look, this is obscene. We so clearly outperform the market. You're still gonna take this deal even if we take more of this, because there's just a mispricing here. This product should not be priced at twenty, twenty-five percent carry. This product should be priced at a much higher carried interest, and you're still gonna love it."
- DRDavid Rosenthal
You should pay twenty percent carry for a firm that delivers you fifteen percent annual returns. We're delivering you fifty percent annual returns [chuckles] .
- BGBen Gilbert
Totally. So I have to imagine it didn't go over well with the existing investors, but they just have so much leverage that what's gonna happen?
- DRDavid Rosenthal
Okay. Once again, I'm sorry, audience, I have to say hold on one more minute for another perspective that I have to offer on the carry element, but I want to finish the story first. Okay, so 2001, they raised the carry to thirty-six percent. 2002, they raise it to forty-four percent. And then in 2003, they actually say, "Hey, we can't incentivize you out of the fund, outside investors. We are gonna kick you out." So starting in 2003, everybody who's an outside investor, who's not part of the RenTech family, you know, current employee or alumni of the firm, gets kicked out.
- BGBen Gilbert
And not all alumni get to stay. There's select alumni that get grandfathered in.
- 1:52:57 – 2:12:32
Post-Simons era, political controversy, and the ‘RenTech tapestry’ playbook
- DRDavid Rosenthal
So after the historic performance during the financial crisis, as I alluded to earlier, Jim retires at the end of 2009, and Peter and Bob become co-CEOs, co-heads of the firm in 2010. They take the portfolio size up to $10 billion when they take over. It had been at five for the last few years of Jim's tenure. They take it up to 10, and really with no impact, which I assume means that RenTech was getting better and the models were getting better, 'cause otherwise they would've gone to 10 before.
- BGBen Gilbert
Right. They gained confidence that they had enough profitable trades they could make, that they could raise the capacity without dampening returns.
- DRDavid Rosenthal
Yes.
- BGBen Gilbert
And perhaps they could have done it earlier, and they just didn't have the confidence that it would work at larger size, but I bet they're very good at knowing how large can our strategy work up to before it starts having diminishing returns.
- DRDavid Rosenthal
Yeah, and importantly, during periods of peak volatility, like, say, 2020, [chuckles] Medallion continues to shoot the lights out. So from at least the data that we were able to find on Medallion's performance over the past few years, 2020, they were up 149% gross [chuckles] and 76% net. So the magic is still there. And one way to look at it, which may not be the be-all and end-all, but I think is a good way to compare Jim's era at Medallion versus Peter and Bob's era, during Jim's tenure, Medallion's total aggregate IRR from 1988, when the fund was formed, to 2009, when he retired, was 63.5% gross annual returns and 40.1% net annual returns, which of course, did include many periods of lower carry, 20% versus the 44%. During the post-Jim era, the Peter and Bob era, from 2010 to 2022, was when we were able to get the latest data, IRRs are 77.3% [chuckles] gross and 40.3% net, so better on both fronts, even with much higher average fees. So yeah, I think Medallion is doing fine.
- BGBen Gilbert
It's amazing. And we weren't able to tell, there's some sources that report that they've grown from $10 billion in the last few years to being comfortable at a $15 billion fund size, and if so, that just means that they continue to find more profitable strategies within Medallion to keep those same unbelievable returns at larger sizes.
- DRDavid Rosenthal
Yeah, and at the end of the day, this is all just insane. So as far as we can tell, Ben, you alluded to this a bit at the beginning of the episode, and as far as anybody else can tell, Medallion has, by far, the best investing track record of any single investment vehicle in history.
- BGBen Gilbert
So give me those net numbers.
- DRDavid Rosenthal
So during the entire lifetime so far of Medallion, from 1988 to 2022, that's 34 years, the total net annual return number is 40%, four zero-
- BGBen Gilbert
Oof!
- DRDavid Rosenthal
... over 34 years after fees. It's 68%- [laughing] ... before fees, which equates to-... total lifetime carry dollars for the whole firm of $60 billion just in carry, by our calculations. [chuckles]
- BGBen Gilbert
Astonishing.
- DRDavid Rosenthal
That is a lot of money.
- BGBen Gilbert
Also, David Rosenthal, good spreadsheet work on this. You have not done a spreadsheet for an episode in a while, so I admire your, uh, your work on this one.
- DRDavid Rosenthal
Yeah. I still know how to use Excel. [laughing]
- BGBen Gilbert
[laughing]
- DRDavid Rosenthal
Barely. It's gonna be a dying art now with Copilot and GPTs.
- BGBen Gilbert
That's right. Okay, so 60 billion in total carry.
- DRDavid Rosenthal
So 60 billion in total carry is a lot of money. And, well, speaking of a lot of money, we do need to mention, before we finish the story here, that that RenTech money has bought a lot of influence in society. So Bob Mercer, that name may have sounded familiar to many of you along the way. Bob was the primary funder of Breitbart and Cambridge Analytica, and one of the major financial backers of both the 2016 Trump campaign and the Brexit campaign in Great Britain. Now, lest you think that RenTech dollars are solely being funneled into one side of the political spectrum, Jim Simons is a major Democratic donor, as are many other folks at RenTech.
- BGBen Gilbert
Yeah, Henry Laufer and other folks are also huge donors, approximately to the same tune as what Bob Mercer is on the right.
- DRDavid Rosenthal
Yeah, tens of millions of dollars, many tens of millions of dollars on all sides and through many campaign cycles here from RenTech employees and alumni. This did become a flashpoint for the firm in the wake of the 2016 election. Mercer obviously became a, uh, controversial figure, both externally and internally within the firm.
- BGBen Gilbert
Especially once people realized he was the through line through Breitbart, Cambridge Analytica, the Trump election, and Brexit.
- DRDavid Rosenthal
Yes. Ultimately, Jim asked Bob to step down as co-CEO in 2017, which he did, but he did remain a scientist at the firm and a contributor to the models, even though he wasn't leading the organization with Peter from a leadership standpoint any longer.
- BGBen Gilbert
Ultimately, the thing that surprised me the most is how these people all still work together, despite having about the most opposite political beliefs you could possibly have.
- DRDavid Rosenthal
[chuckles] Yeah, understatement of the century.
- BGBen Gilbert
And all being extremely influential and active in those political systems. Yes, Bob Mercer is no longer the CEO of Renaissance Technologies or the co-CEO. He still works there. He's still associated. They all still speak highly of each other. It's unexpected.
- DRDavid Rosenthal
Yeah. I think unexpected is the best way to put it.
- BGBen Gilbert
Like everything with Renaissance, it works a little bit different than the rest of the world.
- DRDavid Rosenthal
Yes. Okay, speaking of, let's transition to analysis, and I have a fun little monologue I want to go on, if you will-
- BGBen Gilbert
Ooh!
- 2:12:32 – 2:20:46
Basket options, leverage, and the IRS bill: how the machine amplified—and got audited
- BGBen Gilbert
Yep, I think that's right. Okay, there's a few other parts of the story that we skipped along the way because there was no real good place to put them in, but these are objectively fascinating historical events that are totally worth knowing about, and the first one is called basket options. So the year is 2002. RenTech has thirteen years of knowing that they basically have a machine that prints money. So what should you do when you have a machine that prints money? Leverage. Now, there are all sorts of restrictions around firms like this and how much leverage they can take on. You can't just go and say, "I'm gonna borrow, you know, a hundred dollars for every dollar of equity capital that I have in here." So you need to sort of get clever to borrow a whole bunch of money from banks or from any lender to basically juice your returns if, again, you have a money-printing machine that's reliable. Most people don't. Most people probably shouldn't take leverage because they're just as likely to blow the whole thing up as they are to be successful. So basket options. I am gonna read directly from The Man Who Solved the Market because Greg Zuckerman just put it perfectly: "Basket options are financial instruments whose values are pegged to the performance of a specific basket of stocks. While most options are based on an individual stock or a financial instrument, basket options are linked to a group of shares. If these underlying stocks rise, the value of the option goes up. It's like owning the shares without actually doing so. Indeed, the banks," who, of course, loaned the money, who put the money in the basket option, "were legal owners of the shares in the basket, but for all intents and purposes, they were Medallion's property." So this is very clever. Medallion's saying, "Well, the way we're gonna lever up is there's a basket. We have an option to purchase that basket. Most of the capital in that basket is actually the bank's capital, but the bank has hired us to trade the options in the basket, and then after a year, when long-term capital gains tax kicks in, we have the option to buy that basket." So anyway, all day, Medallion's computer sent automated instructions to the banks, sometimes in the order of a minute or even a second. The options gave Medallion the ability to borrow significantly more than it otherwise would be allowed to. Competitors generally had about seven dollars of financial instruments for every dollar of cash. By contrast, Medallion's option strategy allowed it to have $12.50 worth of financial instruments for every dollar of cash, making it easier to trounce rivals, assuming they could keep finding profitable trades. When Medallion spied an especially juicy opportunity, it could boost leverage, holding close to twenty dollars of asset for every dollar of cash. In 2002, Medallion managed over five billion, but it controlled over sixty billion dollars of investment positions.... David, this exposes something we haven't shared yet on the episode, which is it's not just that they could find five billion dollars worth of profitable trades, it's that they wanted to lever the crap out of five billion dollars and find sixty billion dollars of profitable trades to make. And basket options gave them a legal way to have an incredible amount of leverage in a way that they felt safe about.
- DRDavid Rosenthal
Yeah, the unlevered returns, if you were running this strategy, would be much lower.
- BGBen Gilbert
Yeah. So a big piece of this playbook that we didn't talk about is leverage, but every quant fund does leverage, and so Renaissance was just more clever than everyone else.
- DRDavid Rosenthal
Yeah. It's an important point, though. Nine out of every ten companies that we cover on Acquired, leverage is zero part of the story.
- BGBen Gilbert
Right.
- DRDavid Rosenthal
And for us, coming from the world we come from, in tech and venture capital, leverage is like a dirty word, like, I'm scared of it.
- BGBen Gilbert
Right. I mean, you could imagine, let's say it wasn't they were right fifty point two five percent of the time, but they were right fifty point zero zero zero one percent of the time, they would need to do a ton of trades in order to generate enough profits. So that's why you need, you know, sixty billion dollars of cash to actually execute the strategy to produce the returns that they were looking for-
- DRDavid Rosenthal
Yep
- BGBen Gilbert
- on five billion dollars of equity. Anyway, there's a second chapter to this, which is it's all well and good that this is how they get a bunch of leverage. That's one piece of it. The other piece is they thought this was a remarkably tax-efficient vehicle. The way that they were filing their taxes said, "Oh, sure, there's stuff in that basket, but the thing that we actually own is an option to buy that basket or sell that basket, and we only exercise that once every thirteen months or so." I don't know the exact number, but something like that, over a year. "And so therefore, we're buying something, we're holding it for a year, we're selling it. Oh, of course, there's millions and millions of trades going on inside the basket, but we don't own that basket. The banks do. We're just advising them." You can kind of see the logic here. Over time, eventually, in twenty twenty-one, the IRS said, "No, you made all those trades. That was not a completely separate entity, and so you guys owed six point eight billion dollars in taxes that you didn't pay. You're gonna need to pay that with interest, with penalties. And by the way, Jim Simons, we're gonna want you and the other few partners to really bear the load of that." And they did. So for Simons alone, he paid six hundred and seventy million dollars to the IRS in back taxes for this basket option strategy that turned out not to be a long-term capital gain.
- DRDavid Rosenthal
Yep.
- BGBen Gilbert
All right, so numbers on the business today, and then we will dive into power and playbook. So today, we've talked about Medallion, ten or fifteen billion, depending on who you ask. Historically, it was more like five or ten billion. The institutional fund is about sixty to seventy billion, and at one point was a hundred billion. The total carry generated, David, you said is sixty billion dollars. Forbes estimates that Jim Simons alone is worth about thirty billion dollars today, which kind of pencils with a bunch of other stats over the years that he owned about half of Renaissance. The returns, obviously, the Medallion Fund generated approximately sixty-six percent annualized from nineteen eighty-eight to twenty twenty. After those fees, was about thirty-nine percent. Wild. So an interesting thing to understand, I ran a hypothetical scenario of how much money do you think Renaissance the business makes a year in revenue? And so the institutional fund, let's call it ten percent on sixty billion of assets, so that's six hundred million from fees and six hundred million from performance, so one point two billion a year in revenue to the firm from the institutional side of the business. 'Cause I always ask myself the question: Does that actually matter? They did all this work to stand up the institutional side. Who cares? Well, let's say Medallion does their average sixty-six percent gross on fifteen billion. That is seven hundred and fifty million in fees and four point three billion on performance.
- DRDavid Rosenthal
[laughing]
- BGBen Gilbert
So a total of five billion from Medallion and one point two billion from the institutional side of the business. Now, of course, the employees are the investors in Medallion, so you could just argue it's actually silly to cut them up, but I don't know, it's a seven, eight, nine billion dollar revenue business.
- DRDavid Rosenthal
Right, 'cause that's not including the LP return on Medallion.
- BGBen Gilbert
A hundred percent, it's not.
- DRDavid Rosenthal
Which, again, as we spent a long time talking about, it's all the same thing.
- BGBen Gilbert
Yes. But it's kind of interesting just to compare it against other companies, to have this in the back of your head. This is a seven, eight billion dollar a year revenue business.
- DRDavid Rosenthal
Now, I think there are a lot of expenses on the infrastructure side.
- BGBen Gilbert
Totally. That was another thing I wanted to talk about, the fact that they do... Let's say Medallion alone, so they'd have seven hundred and fifty million dollars in fees. I don't think they come close to seven hundred and fifty million dollars a year in expenses, but they are running who knows what infrastructure, some kind of supercomputing cluster. What does it cost to run one Amazon data center? I mean, it's, I think, much smaller scale.
- DRDavid Rosenthal
I don't know. I mean, you're talking about a lot of data here.
- BGBen Gilbert
Yeah, it says right on their website, they have fifty thousand computer cores with a hundred and fifty gigabits per second of global connectivity and a research database that grows by more than forty terabytes a day. That's a lot of data.
- DRDavid Rosenthal
Right. Is that seven hundred and fifty million a year? I don't know, but it's not zero. [chuckles]
- BGBen Gilbert
I don't think so. They're certainly not losing money [chuckles] on the fees, but there are actual hard costs to this business.
- DRDavid Rosenthal
Right. I wonder, too, if the fee element of Medallion basically pays the base salaries for the current team.
- 2:20:46 – 2:51:01
Seven Powers analysis, playbook lessons, and closing reflections
- BGBen Gilbert
That feels like it's right. If you're, uh, someone who has done a data center build-out before or has any way to sort of back into what the costs of Medallion's operating expenses are on the compute and data and network side, we would love to hear from you, hello@acquired.fm. Okay, power?
- DRDavid Rosenthal
Power. [sighs] This is a fun one.
- BGBen Gilbert
Yeah, so listeners who are new to the show, this is Hamilton Helmer's framework from the book Seven Powers. What is it that enables a business to achieve persistent differential returns to be more profitable than their closest competitor on a sustainable basis? And the seven are counter-positioning, scale economies, switching costs, network economies, pro-... process power, branding, and cornered resource. And David, my question to you to open this section is specifically about RenTec's lifelong non-competes. That feels like a big reason that they maintain their competitive advantage, and I'm curious if you agree with that. What would you put that under?
- DRDavid Rosenthal
Well, I think it's lifelong NDAs and non-competes as long as the state of New York legally allows for- [chuckles]
- BGBen Gilbert
Hmm.
- DRDavid Rosenthal
-but that it's not lifetime. I've heard various figures, six years, five years, something like that.
- BGBen Gilbert
Yep.
- DRDavid Rosenthal
I mean, at the end of the day, non-competes are more like, what is one side willing to go to court over? [chuckles]
- BGBen Gilbert
Right.
- DRDavid Rosenthal
But the reality is, people don't leave. People don't leave, period, and people especially don't leave and start their own firms.
- BGBen Gilbert
Yep.
- DRDavid Rosenthal
I was thinking about this in the middle of the night, and I think there's three layers to the effective non-compete that happens with RenTec. There's the legal layer, the base layer that you're talking about. It's like the agreements you sign. Then there's the economic layer of what we spent a long time talking about in Tapestry of it would just be dumb to leave. You are better off staying there as part of that team with a smaller number of people than going to Two Sigma with a lot more people.
- BGBen Gilbert
Yep.
- DRDavid Rosenthal
I think that's the next level up, and then I think the highest level is just probably the social layer. You're there with the smartest people in the world in a collegial atmosphere, where you're all working hard on something that has direct impact on you.
- BGBen Gilbert
Right, it's your community.
- DRDavid Rosenthal
It's your community, totally. You're not in New York City, you're not in the Hamptons, you're not in Silicon Valley. You are selecting into that, and I think if that's what you want, then, like, what better place in the world?
- BGBen Gilbert
All right, so classify it. What power does that fall under?
- DRDavid Rosenthal
Well, I mean, I think the people specifically, you would put into cornered resource, but I'm not actually sure that fully captures it here. I was thinking more process power, 'cause I think it is the combination of the people, and the model, and the incentive structures. [chuckles]
- BGBen Gilbert
Yep. I think that's right. I also had my biggest one being process power. You actually can develop intricate knowledge of how a system works and then build processes around that that are hard to replicate elsewhere. I think these systems have been layered over time also, where anyone who's come into the firm in the last five years doesn't know how it works start to finish. I didn't ask anyone to verify that, but it's over ten million lines of code, and the level of complexity of the system of when it's putting on trades, what trades it's putting on, why, the speed at which they need to happen, I actually don't think anyone holds the whole model in their head. And so I think there's process power just because it's thirty-plus years of complexity that's been built up.
- DRDavid Rosenthal
Yep. I totally agree with that, particularly in the model itself. I mean, maybe you could argue the model is a cornered resource.
- BGBen Gilbert
I am going to argue that the data-
- DRDavid Rosenthal
Oh, okay.
- BGBen Gilbert
-is a cornered resource. I don't know for sure about the model. Maybe? I mean, I guess that's the same thing as saying the knowledge of what the ten million lines of code does, that's the model. But I actually think the fact that they have clean data and they've been creating systems... Like, they have the best PhDs in the world thinking about data cleaning. That's not a sexy job, and yet they have probably the treasure trove of historical market data in the best format that nobody else has. That's an actual cornered resource.
- DRDavid Rosenthal
I have a couple nuances on this. So one, I think it probably is true that they have better data than any other firm, thanks to Sandor Straus and the work that he started doing in the '80s before anybody else was really doing this.
- BGBen Gilbert
Yep.
- DRDavid Rosenthal
So they have that, and other firms don't. That said, certainly, all the other quant firms are throwing untold resources [chuckles] at all this, too.
- BGBen Gilbert
Right, they wanna do this, and money is not the issue.
- DRDavid Rosenthal
So in chatting with a few folks about this episode, I had more than one person say to me: "There's two ways that RenTec could work, and one version of how it works is they discovered something twenty-plus years ago that is a timeless secret, and they've been trading on that for twenty-plus years."
- BGBen Gilbert
Right. There's one particular relationship between types of equities that they've just been exploiting, and no one can figure out except them.
- DRDavid Rosenthal
Right, and that may entirely be possible.
Episode duration: 3:10:44
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