How back-testing can bamboozle investors

By: Tim Bennett
This week, Tim Bennett explains why investors should be wary of past performance claims when it comes to buying new funds.

How back-testing can bamboozle investors

Firms bringing a new product to the market for the first time will often cite past performance data. The problem is that this is often back-tested data, created to imply that the product has a solid performance history when in fact it has none. Investors should be wary.

Why back-test at all?

Exchange traded fund providers are all battling to distinguish the growing number of products available to retail investors, particularly in the “smart-beta” or “factor investing” space. The result is a proliferation of new ETFs that all claim a unique strategy. This creates a headache when it comes to supplying past performance data – if a product is brand new there won’t be any. A common solution is to, therefore, pick a past period and try to show what would have happened had such a product existed.
It all sounds sensible enough. However, as wealth manager and blogger Ben Carlson notes;

What can go wrong?

The natural temptation for fund providers is to data-mine i.e. select past data that makes a new product look great. And even if the data selected is objective, you are still looking at past data which, by definition, is out-of-date – put simply, what used to work is not the same thing as what will work going forward.
Research Associates have looked at data from 125 different indices created to support new ETFs. The pattern they spotted is that the strong outperformance published for the three years prior to launch was not matched in the 60 months that followed. Indeed most of these products averaged little better performance than the S&P 500.

What’s going on?

There are several reasons for this;

1.       Mean-reversion laws apply here – periods of outperformance for any fund rarely last as competitors spot an opportunity to join the party

2.       Investors tend to flock to successful products and quickly make them more expensive

3.       Even the cleverest strategies don’t work forever as market conditions change

What to do

It’s all too easy to believe the marketing hype.
Diligent investors will take back-tests with a pinch of salt – challenge the investment assumptions being made to support past performance for any new product before buying.