Don’t believe in financial market unicorns.
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!
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!”
- 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?
The recent headline is a great empirical example that unicorns don’t exist in the real-world.
[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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Definitions of common statistics used in our analysis are available here (towards the bottom)