Warren Buffett (Trades, Portfolio) is often considered to be the greatest investor of all time, and with good reason - what he has been able to do with Berkshire Hathaway (BRK.A)(BRK.B) arguably dwarfs anything else in corporate America. However, in terms of annual returns, there are other investors who are ahead of Buffett. Jim Simons (Trades, Portfolio) is at the head of that pack. The annualized average returns of his Medallion Fund before fees come out to a whopping 66%.
How did he do it? By building a mathematical model. Simons was originally a mathematician who dabbled in trading, but found the emotional ups and downs of decision-making too hard to handle. He sought to build a completely automated system that would take the human factor out of investing. I recently found an interview of his where he was asked about the future of quantitative investing and trading.
How have computers changed fundamental investing?
Simons was asked whether he believes the proliferation of computerized trading has changed fundamental investing for good, and indeed whether he believes fundamental investing can be done at all any more. He said:
“It’s a perfectly legitimate way to invest. It’s a world of difference [between fundamental investors and quants]. A good fundamental investor in a company wants to evaluate the management, have a sense of the human beings running the thing. He wants to have a sense of where the market might be going. It’s a set of skills, and some people are very good at it. Quantitative stuff is a different set of skills, which suited me.”
Commentators often point to the rise of computerized trading and investing as something that has completely wiped out old-fashioned investing, but clearly this giant of the quantitative school thinks otherwise.
Will quants go extinct?
Another interesting aspect of investing that Simons commented on was whether or not quants would one day themselves become obsolete. Quantitative investors make money by finding and exploiting inefficiencies in the market, and end up smoothing those inefficiencies out. If they do this enough, at some point there will be no inefficiencies left to exploit, or so the thinking goes. Here’s what Simons had to say on the issue:
“Yes, inefficiencies do eventually get traded out when they’re discovered. But the market is not static. It’s dynamic, things change, and there is room, I think, for new inefficiencies to materialize. I think it’s never going to be that all inefficiencies are out, there’s nothing to discover. On the other hand, so far our returns have been more or less stable for a long time. But, we keep finding new things, and keep throwing out things that are no longer working.”
I would add to this that the very presence of large computerized traders in the market is enough to cause new inefficiencies to appear. As Simons says, the market is always moving, and the action of one participant has many knock-on effects. So it seems unlikely there will come a time when there are no more inefficiencies. And that is something that all investors, both human and computer, should cheer about.
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