By |Published On: October 20th, 2015|Categories: Uncategorized|

Financial market unicorns are the magical market elves that grind out eye-popping compound annual returns for multiple years and with limited volatility. I’m sure you’ve heard the pitch:

XYZ made 30% returns after 2/20 fees for 20 years before they started this fund. You should invest.

Unfortunately, the human brain is wired to falsely assume that the manager’s past performance, which was probably driven by a different process than the one in the new fund, will somehow translate into performance for the new fund.

But there is something even more corrosive going on behind the scenes. The human brain is accepting the unicorn-like performance as a fact!

Unicorns, of course, are impossible (almost) because sustainable active investing is challenging, and because the math doesn’t add up.

Having reviewed and analyzed hundreds of “hedge fund” pitchbooks and strategies over the years, I have 2 new rules when it comes to assessing unicorns:

  • Null Hypothesis: Investors can have a long-term edge, but Unicorns don’t exist.
  • Show me the money: Only consider live track records after you’ve seen the official audited returns.

Why should we NOT believe in unicorns?

Consider the field of marketing science. Robert Cialdini has a great book called, “Yes! 50 Scientifically Proven Ways to be Persuasive,” in which he highlights the power of stories to influence our decision-making. So how might this work?

Take the accounts of Renaissance Technologies. The storyline is absolutely breathtaking and highlights that Jim Simons is an incredible math–and marketing–genius.

Imagine the following story: RenTec has generated 35% returns after 5% management fees and 44% percent performance fees with limited volatility. The team consists of genius mathematicians with magical wands that thwart market competition. Would you like to invest in the genius’ fund?
My gut reaction: “Heck, yeah!”

Rational reaction:

  1. Where are the audited track records?
  2. Why would the performance of this unicorn fund (assuming #1 checks out) apply to the fund I’m investing in? Is the process even the same?

The recent headline is a great empirical example that unicorns don’t exist in the real-world.

Renaissance Shuttering $1B Institutional Futures Fund For ‘Lack of Interest’

[the fund] is down 1.75% so far this year through September, and has booked average annualized net returns of 2.86% since inception in 2007.

2.86% annual returns since 2007? Ouch.

Now, don’t get me wrong, I’m sure RenTech has a sustainable edge that will degrade with the size of their asset base, and maybe this specific fund bested the benchmark by a wide margin, but it is both instructive and humbling to see that the masters of the universe don’t actually control the financial market universe. 35% annual returns with limited risk simply don’t exist in the competitive marketplace (on a large scale, at least). Markets are too efficient. Likewise, even though we may hope there are magical rainbow unicorns in the forest, they simply don’t exist either.

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About the Author: Wesley Gray, PhD

Wesley Gray, PhD
After serving as a Captain in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago where he studied under Nobel Prize Winner Eugene Fama. Next, Wes took an academic job in his wife’s hometown of Philadelphia and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management firm dedicated to an impact mission of empowering investors through education. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. Wes has published multiple academic papers and four books, including Embedded (Naval Institute Press, 2009), Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016). Dr. Gray currently resides in Palmas Del Mar Puerto Rico with his wife and three children. He recently finished the Leadville 100 ultramarathon race and promises to make better life decisions in the future.

Important Disclosures

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Third party information may become outdated or otherwise superseded without notice.  Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy, or confirmed the adequacy of this article.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).

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