Don’t believe in financial market unicorns.

Don’t believe in financial market unicorns.

October 20, 2015 Uncategorized

Last updated on March 19th, 2017 at 05:20 pm

Print Friendly

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?

484431374_c0062a999a_z

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.


Note: This site provides no information on our value investing ETFs or our momentum investing ETFs. Please refer to this site.


Join thousands of other readers and subscribe to our blog.


Please remember that past performance is not an indicator of future results. Please read our full disclaimer. 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. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.




About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. 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.