Damned Lies and Statistics

“There are three kinds of lies: lies, damned lies, and statistics.” – Mark Twain in Chapters from My Autobiography (attributed to British Prime Minister Benjamin Disraeli)

It was an unusually warm November morning in 2008. Louis Winthorpe IV enters a towering skyscraper on 5th Avenue. As the elevator ascends to the 59th floor, Louis reflects fondly on the journey that led him here: Choate, Yale, and summering in the Hamptons.

With blue blood running through his veins, Louis couldn’t help but grin as he walked through the doors of White Shoe Investments, the most venerable firm in all of Wall Street. He was five months into his career as a hedge fund analyst, a coveted position for recent graduates.

Louis sat down at his cocobolo desk and began flipping through his inbox. He had been working for a month on a special project for one of the managing partners at the firm: Mortimer Duke II. The task: find the next great investment fund opportunity for the firm.

Under Mortimer’s tutelage, Louis had quickly learned the ins and outs of selecting investments, but this was the first time he alone would be making a proposal. At first the thought of being responsible for a new idea in the firm’s investment portfolio excited Louis, but with only one day left to complete his findings that excitement had shifted to nervousness and anxiety.

There were thousands upon thousands of funds, an impossibly high number to sift through on a qualitative, discerning basis. Louis had already reviewed all of the top prospects from the firm’s “Glengarry Leads” list, but it was 2008 and nearly all had been tarnished with the stock market crash, on pace for its worst year since the Depression.

He walked into Mortimer’s office and explained his dilemma.

Mr. Duke, a distinguished alumnus of Philips Exeter and Harvard, did not suffered fools gladly. “Didn’t they teach you anything at that second-rate school they call Yale? What are the two P’s?”

“Pedigree and Performance,” Louis quickly responded. “But this is a financial crisis and all of the high pedigree managers are losing money. Finding good performance with a repeatable process is not an easy…”

“Spare me the details,” Mortimer interrupted. “I don’t want to ever hear about this “process” nonsense again. You can’t eat process; you can only eat performance. We buy past returns, son. The best of the best and nothing less. If you can’t find someone with an impeccable track record, then maybe you’re not cut out for this line of work. I hear there’s an opening in accounting.”

With that, the conversation was over, and Louis returned to his desk. The mere thought of an accounting job nauseated Louis to no end. He was far above such mundane and menial tasks. He had always been among the best and the brightest and was destined for nothing less than an accomplished and lucrative career in investments.

“We buy past returns,” Louis said to himself, over and over again, repeating the words of Mr. Duke. In working with him, Louis had conducted countless calls with prospective managers. They all ended with the same five words: “send me the monthly returns.”

A light bulb went off in Louis’ head. Mortimer is simply looking for the perfect return stream. Well, what would the perfect return stream look like, he pondered. It would have high returns, low volatility, consistently positive performance, and extremely low drawdowns.

Could it be that simple? Perhaps Louis had been overthinking this job all along. Well versed in math and statistics, Louis began screening for these attributes, narrowing down the candidates. In the end, there was one fund that stood out above all others.

High returns? Check. Low volatility? Check. Consistently positive performance? Check. Low drawdowns? Check.

It was the Holy Grail of investments and he had discovered it. Louis wrote up his report with alacrity. He could not wait to present it to the firm the next morning.

The investment committee met at 9am sharp and was comprised of all of the managing partners at the firm. Louis was confident but worried that there was something he might be missing. He couldn’t bear the thought of rejection and forced himself to think positively.

There were four new investments to be presented at today’s committee. One was a short-biased equity fund that had done fantastically well thus far in 2008. The next was a fund that had profited handsomely from shorting subprime securities. The third was a black swan fund that was long volatility and just recorded a monthly return of over 50%.

Louis’ nerves were calmed in hearing these presentations. They were all approved and had one consistent theme in common: good past returns, particularly in the recent past. His recommendation was no different, he thought to himself, and should receive similar approval.

It was time. Louis began with an astonishing array of statistics…

“17+ year track record at a well-established firm”

“10.6% annualized returns”

“2.72 Sharpe Ratio”

“1.22 Treynor Ratio”

“92% of months were positive”

There was a look of intrigue on all of their faces. Louis knew he had their attention but he was not done, far from it. He had saved the most impressive stats for last.

“No down years, up thus far in 2008”

“Maximum Drawdown of less than 1%”

“Ratio of annualized return to max drawdown: 16.49”

He finished with a bang…

“And everything I just mentioned are the unlevered return stats. There is a 3x version with more impressive stats being offered by a major investment bank … with daily liquidity.”

The room fell silent. For a brief moment, Louis feared the worst. Had he said something wrong? Were the stats not good enough?

Then it began: a slow, resounding clap, culminating in rapturous applause. “Well done, Louis,” said Mortimer with gusto. “Well done. You keep this up and one day you’ll be a partner at this firm.”


Louis left the office that night on cloud nine. Nothing could bring him down, not even having to wait a half hour to be seated for dinner at Nobu. It would take a few weeks to complete the paperwork and to choose between the 1x and 3x version, but they would be talking about his investment idea for years to come. How could they not? It would be the gold standard, he thought to himself, held up as something everyone at the firm should be striving for.

It was a cold Thursday afternoon in December. Louis was busy at work searching for the next great investment idea. He had narrowed the list to a few top candidates, all with great past returns, of course, but he was holding out hope for another home run. “Send me the monthly returns,” he said in finishing a call with a one of the top-performing fund managers of 2008. Crunching the numbers, he would soon learn that this fund had a 20% drawdown years ago; he knew that would be unacceptable to the partners. Not to mention the fund had not one but two down years, a complete non-starter. Dismayed, Louis went back to the drawing board.

Then the news hit.

“Prominent Trader Accused of Defrauding Clients”

Intrigued, Louis clicked on the link.

“On Wall Street, his name is legendary. With money he had made as a lifeguard on the beaches of Long Island, he built a trading powerhouse that had prospered for more than four decades. At age 70, he had become an influential spokesman for the traders who are the hidden gears of the marketplace.

But on Thursday morning, this consummate trader, Bernard L. Madoff, was arrested at his Manhattan home by federal agents who accused him of running a multibillion-dollar fraud scheme — perhaps the largest in Wall Street’s history.”

Louis’ heart sank, recognizing Madoff as the underlying manager of Fund he had recommended a month early: Fairfield Sentry. And there it was…

“The Madoff funds attracted investors with the promise of high returns and low fees. One of Mr. Madoff’s more prominent funds, the Fairfield Sentry fund, reported having $7.3 billion in assets in October and claimed to have paid more than 11 percent interest each year through its 15-year track record.”

I know what you’re thinking. This story ends with Louis and his firm learning a valuable lesson about the dangers of buying past returns with the best statistics. Sorry to disappoint. As it turns out, White Shoe Investments got very lucky. There had been a delay in completing the paperwork and no money had been transferred to Fairfield Sentry. No one was the wiser. None of their old money investors would ever find out that they came this close to being involved in the worst fraud in history.

White Shoe Investments would grow and prosper, delivering consistently underwhelming returns but never deviating from their tried and true method of buying the best performing funds. Ironically, their clients seemed quite happy with their subpar returns. As long as they were investing with the “best of the best” and telling their friends as much, they were pleased.

White Shoe’s strategy of searching for winners with good Sharpe ratios and low drawdowns would become widespread across the industry, as recently chronicled in the scathing Hedge Fund Myth. Indeed, it would become the gold standard.

The blame for the Fairfield Sentry near-miss? It would fall on the operational due diligence group at White Shoe. “Those incompetent fools should have uncovered the fraud,” said Mortimer, “that’s what we pay them for.” The investment team was unscathed and undaunted by the whole experience. As for Louis, he rose through the ranks at White Shoe, becoming the youngest partner in the firm’s history. You can find him there today, still on 5th Avenue but now in his corner office with a grand view of the park. Searching, ever searching, for the perfect track record.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.



Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

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