Pioneering Fund Stages Second Act

By SCOTT PATTERSON And JENNY STRASBURG

EAST SETAUKET, N.Y.—The founder of Renaissance Technologies LLC, one of the most successful hedge-fund companies ever, is trying to pull off a feat few other investment impresarios have managed: passing the torch.

James Simons, the secretive mathematician and Cold War code breaker who founded the firm in 1982, stepped down as chief executive in January. A pioneer in utilizing powerful computers to comb markets for trading opportunities, Mr. Simons has long received credit for the firm's hefty returns.

Now Peter Brown and Bob Mercer, two lieutenants of Mr. Simons all but unknown to the investing world, must steer the firm through challenging waters. The firm's main funds open to outside investors have posted mediocre results, and Messrs. Brown and Mercer, who are co-CEOs, say they are mulling whether to shut them down.

Mr. Simons made his reputation on his signature fund, called Medallion, which has posted average returns of about 45% a year, after fees, since its inception in 1988. Since 1995, it has had only one money-losing quarter, slipping 0.5% in the first quarter of 1999, according to documents reviewed by The Wall Street Journal. Medallion's returns have outpaced those of Warren Buffett, whose Berkshire Hathaway Inc. has gained roughly 20% a year since Mr. Buffett took over in 1965.

The $10 billion fund, however, is now closed to outside investors, leaving them with two newer funds if they want a piece of the action. Those two funds, Renaissance Institutional Equities Fund and Renaissance Institutional Futures Fund, claimed combined assets of about $30 billion in 2007, which made Renaissance one of the biggest hedge-fund operators in the world. But disappointing returns over the past few years have led to a wave of investor withdrawals, and combined assets have plunged to $6 billion.

In their first media interview, conducted at the firm's headquarters on Long Island's North Shore, the two new chief executives said they are examining whether to shutter the two funds. "If we assess that it's not something that's going to sell, then we'll decide it's not good to be in that business," Mr. Brown said. That would turn Renaissance into a hedge fund open almost exclusively to a small inner circle, most of them employees.

Some managers of large hedge funds have successfully groomed new leadership. George Soros, for example, years ago stepped back from managing day-to-day operations at Soros Fund Management LLC. But more often, when a founder whose personality dominates a firm steps aside, the firm closes or splinters. That was the case with firms founded by well-known investors Julian Robertson Jr. and Arthur Samberg.

Founder James Simons was a quantitative-trading pioneer.

Mr. Simons, 71 years old, has been planning the succession for years. Messrs. Brown and Mercer, experts in computers and voice-recognition technologies before joining Renaissance, have long been central to the firm's success. Mr. Simons will continue as chairman. He intends to devote more time to philanthropic work, including math education and fighting autism, and to spend time on his 219-foot yacht, Archimedes.

In the 1980s, Mr. Simons, who shuns the public eye, was among the first to develop a form of trading that used mathematical models and computers to predict markets. In the process, he blazed a trail followed by a slew of hedge funds that rely on quantitative strategies—so-called quants—such as D.E. Shaw Group, AQR Capital Management and Citadel Investment Group.

Nearly all of the Medallion fund's trading is automated, involving little to no human interference. Computers are programmed to buy and sell assets of all kinds, attempting to predict whether they will rise or fall based on historical patterns.

In the fund's early years, Mr. Simons focused chiefly on futures, contracts tied to the price of commodities, currencies and other assets. But under the guidance of Messrs. Brown and Mercer, Medallion's stock-trading operation has become its chief money maker, now accounting for more than three-fourths of its returns, says a person familiar with the matter.

The computer programs scrutinize the pricing of related securities. For example, shares of Exxon Mobil Corp. and Chevron Corp. historically tend to trade in similar directions, since their fates hinge on oil production and prices. If Exxon's stock starts to rise, but Chevron's doesn't, Medallion might purchase Chevron and sell Exxon short, hoping to benefit as the two stocks move back into alignment.

In reality, Medallion's strategies are far more complex, factoring in variables that affect stocks and other securities traded on electronic exchanges. "We try to find these very obscure patterns hidden in a lot of noise, and hopefully things are stationary enough for the next second or minute or year," says one Renaissance researcher.

The firm is known for fast trading, often holding stocks and futures contracts for only minutes, or even seconds. (Sometimes it holds positions for weeks or longer.) The horsepower for the vast trading operation is supplied by computer servers—the firm has given them names like Laddersnake, Howler3 and Neon—that stand in row after row of 6 1/2-foot-tall metal cages, in three rooms the size of tennis courts.

Renaissance employs about 90 holders of Ph.D.s to man the operation, including experts in quantum physics and artificial intelligence. Because nearly all trading is automated, the office doesn't have much of a trading floor. Most employees work in their own offices, swapping ideas in a lecture hall or in the firm's library, which is adorned with a fireplace.

 
Bob Mercer, left, and Peter Brown, right, recently became co-CEOs of Renaissance Technologies.
Mr. Brown, 55, and Mr. Mercer, 63, have been working together since the 1980s, when both developed voice-recognition technology for International Business Machines Corp. Mr. Brown, who has a Ph.D. in computer science from Carnegie Mellon University, is talkative, politically liberal, and competitive, given to challenging employees to feats of strength in the office gym.

Mr. Mercer, a political conservative and National Rifle Association member with a Ph.D. in computer science from the University of Illinois, is in many ways his opposite. He is known to whistle to himself during meetings, and rarely interacts with employees outside official meetings. He enjoys toying with a huge model train in his basement. "I'm happy going through my life without saying anything to anybody," he says.

For years, neither of them had much interest in investing. At IBM, their work focused on using computers to solve voice-recognition and language-translation problems, such as translating French into English.

In 1993, they were contacted by Nick Patterson, a Renaissance researcher they had met while doing code-breaking research for the Defense Department. "I realized that there are some deep technical links between the way speech recognition is done and some good ways of predicting the markets," Mr. Patterson says.

Mr. Brown threw away a letter from Mr. Patterson. Mr. Mercer, intrigued, paid Renaissance a visit. Afterwards, he persuaded his colleague they should make the move. After joining Renaissance, Mr. Mercer asked its chief scientist, Henry Laufer, whether the firm had a retirement plan. "The retirement plan is to get rich," Mr. Laufer responded.

Before they arrived in 1993, Renaissance bought a computerized-stock-trading firm founded by ex-Morgan Stanley mathematician Robert Frey. Renaissance called the new operation Nova. When Messrs. Brown and Mercer arrived, it was struggling.

The two newcomers threw themselves into the project. They shared a nearby apartment, but Mr. Brown frequently slept in his office. He rode a unicycle around the workplace to save time. (On weekends, he returned to New York City, where he lived with his wife, Margaret Hamburg, a physician who is now commissioner of the Food and Drug Administration.)

Messrs. Brown and Mercer improved Nova's trading models, cutting down on human trading decisions. After some initial bugs were worked out, the models succeeded. In 1997, Nova was folded into Medallion, helping to diversify returns. By 1999, stock profits roughly equaled profits from futures trading, according to fund documents.

Messrs. Brown and Mercer assumed more responsibilities at Renaissance, and were increasingly viewed by insiders as likely heirs apparent. Their ascent sparked some resentment from Medallion's futures-trading group, which once had dominated the firm, according to people familiar with the firm. Researchers in both groups attempted to create new computer models to dominate trading, these people say. But the models that Messrs. Brown and Mercer helped create proved the most successful over time.

In 2002, over a lunch of cheeseburgers at Billie's 1890 Saloon in Port Jefferson, Mr. Simons unveiled his plan to relinquish control of Renaissance. "You'll take over," he told Mr. Brown, explaining that Mr. Mercer would be co-CEO.

But new projects kept cropping up, delaying the succession. One initiative spearheaded by Mr. Simons marked a significant departure for Renaissance: a stock fund open to outside investors. In 2005, he launched Renaissance Institutional Equities Fund, or RIEF, which employed a different investing model than Medallion. It would trade stocks of companies on U.S. exchanges only, over a longer time horizon, with the stated goal of beating the Standard & Poor's 500-stock index by a few percentage points over a three-year period. Mr. Simons boasted to investors it could handle $100 billion in assets profitably—something Medallion's models could not do.

Investors poured in. In late 2007, the firm opened Renaissance Institutional Futures Fund, or RIFF. It focused on futures contracts on bonds, currencies, commodities and other assets. Like RIEF, it held positions longer than Medallion.

Renaissance unleashed a mass marketing effort that used Wall Street brokers to bring in investors. Brokers frequently invoked Medallion's success in their marketing pitches. Renaissance noted Medallion's trading success in marketing materials. In a letter he wrote introducing RIEF, Mr. Simons invited investors to take advantage of the Medallion trading models and research teams through the new fund, a message that overshadowed the strategy differences.

Early that August, the first signs of the credit crisis appeared. Big losses started to hit Renaissance and other quantitative hedge funds. Messrs. Brown, Mercer and Simons huddled in Mr. Brown's office with several other top advisers to try to contain the damage. They had to decide how much to cut back their investment positions, which were rapidly losing value. Mr. Simons recommended a moderate reduction of the firm's trading positions.

During its worst period that month, Medallion plunged about 20%, losing about $1 billion, and RIEF fell nearly 10%. But the market surged back, and Medallion and RIEF posted profits for the month.

Medallion gained 80% in 2008, a disastrous year for the stock market, thanks in part to its focus on taking advantage of short-term swings, both up and down, in all kinds of markets. But the newer funds, hampered by their longer-term focus, struggled. RIEF, the larger one, lost 16%. While that bested the broader market, some investors were upset that returns were so much worse than Medallion's. Last year, RIEF lost 6%, much worse than the 26% gain by the S&P 500.

Messrs. Brown and Mercer say they plan to change little about the firm. They acknowledge, however, that they might opt to shut down the two funds. They say RIEF has met its objective of beating the broader market over time, but concede that it hasn't lived up to expectations. In discussions in late January with investors and with Mr. Simons, they said they were reviewing their options.

At Renaissance's headquarters, there is no evidence the firm plans to retrench. Heavy machines are preparing for the construction of new buildings to house more computer servers, offices, and possibly a squash court for employees.

The two new leaders say they're well prepared, but concede that pressure will increase if the two funds continue to suffer. "Other people's money is like a lever on your anxiety," says Mr. Brown.