If there has ever been a money-making machine on Wall Street, it is the Medallion fund. Between 1989 and 2000, it returned 36% after fees. Between 2000 and 2013, it returned 21% after fees, including a 98% return in 2008 when the S&P 500 lost 38%. The fund has managed to extract more than 60 billion dollars from financial markets during its 30-year existence.
The quant fund was started in 1986 by the mathematician Jim Simon. The fund had a strong start by allocating 85% of its capital to trend following models and only 15% to short-term trading models.Then, it had a 25% drawdown in 1989. Simon suspended trading and spent the next six months studying what went wrong. Simon’s conclusion was that their trend following models had run out of juice. Too many commodity funds were using the same systems, which has eroded an edge that used to work wonderfully in the 70s and most of the 80s. Simon decided to make short-term signals the new heart of his trading system. His thesis was that small short-term gains can compound fast.
How did they manage to consistently make so much money for so long when most hedge funds are one-hit wonders or mediocre from the start?
The number one reason is by constantly innovating and experimenting, by creating systems that don’t look intuitive to the human mind. Great computer programs think in a completely different manner than human brains. Medallion has never hired an economist. It prefers to hire PhDs in mathematics, physics, statistics, computer science, chemistry. They focus on developing unconventional edges. Their system trades several hundred different models. The edge of each model is minor when taken individually. But when taken as a whole, the hundreds of minor edges add up to substantial returns.
The number two reason is that Medallion managed to keep its system a secret or at least it has made it so complicated that it is not easy to replicate by ex-employees. The only way to keep a secret is to make your employees rich and incentivize them to keep innovating. Medallion asks their employees to invest 20% of their salary in the fund and don’t let them redeem it for four years after leaving the fund. Also, they have closed the fund to outside investors.