Don’t believe in financial market unicorns.

Don’t believe in financial market unicorns.

October 20, 2015 Uncategorized
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(Last Updated On: March 19, 2017)

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?

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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 R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, 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 that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.


  • IlyaKipnis

    Hmmm…35% returns with limited risk may exist IMO. The hard part is being absolutely sure that the anomaly being exploited A) actually exist and aren’t the product of data-mining and B) can be done at scale. I should have a blog post addressing the latter. IMO one “finger in the wind” way of checking how scalable a solution is works like this:

    A lot of amateur backtests work on an “observe the close, buy the close” basis. Well, what happens if that backtest instead turns into “observe the close, buy tomorrow’s open”, or “observe the close, buy tomorrow’s close”? If the performance goes out the window, well, that strategy is directly limited by how much capital actually trades in that security. It’s something that’s easily overlooked because “who has enough capital to move the markets”, but if you hope to become a millionaire off of a strategy, it will definitely need more capacity than “buy in the last minute of trading”.

  • Agree. They can certainly exist, but at limited scalability and/or with insane risk (i.e., return is roughly commensurate with risk).

    That basic concept is a good rule of thumb for sure

  • jimhsu

    Many of these “black box” strategies trade short-term volatility for extreme long-term tails. In otherwise, they operate on Taleb distributions. This fits the “2/20” compensation model just fine, because managers only have to worry about returns per quarter, which will be great.

    A couple of common themes:
    – Overparametrization and curve fitting
    – Short/very short-term holding periods
    – “Uncorrelated”
    – Unintuitive / many working parts
    – *Large* amounts of leverage
    – Model-based

    Except for the last bit, that sounds like the complete antithesis of sustainable active investing.

    More of what I’m talking about: http://globalslant.com/2015/06/black-box-trading-why-they-all-blow-up/

  • Paul Ramer

    If this is the Rentec fund that I think it is, the original claim was they had $100bb capacity. This is definitely a case of “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?” I am pretty sure the processes are quite different between the two funds.