Why You Shouldn’t Believe in Financial Market Unicorns

Wesley Gray |

Hms_unicorn_close_up.jpg

Financial market unicorns are the magical creatures of the market that grind out eye-popping compound annual returns for multiple years and with limited volatility. You’ve probably 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 something even more corrosive has been 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 devised two new rules for 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 is it NOT a Good Idea to 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 account of Renaissance Technologies. The storyline is absolutely breathtaking, as it highlights the fact that Jim Simons is a genius at math–and marketing.

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?

Gut Reaction: “Heck, yeah!”

Rational Reaction: Where are the audited track records?

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?

This recent headline is a great empirical example of how 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.

A 2.86% annual return since 2007? Ouch.

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. Thirty-five percent annual returns with limited risk simply don’t exist in the competitive marketplace. Markets are too efficient. Likewise, even though we may hope there are magical rainbow unicorns in the forest…they don’t exist either.

Why You Shouldn’t Believe in Financial Market Unicorns was originally posted by Wesley R. Gray at Alpha Architect. Please read the Alpha Architect Disclosures at your convenience. 

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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