A shift to quantitative investment strategies, including indexing, has lowered the bar for market-validated manager track records, specifically for just-in-time exchange-traded products that address acute concerns like duration risk, credit risk or currency exposure.
According to research from ETF.com, just more than 400 products linked to non-market-cap-weighted indexes and strategies — including equal weight, long-short and factor based — attracted a net $42 billion in 2013 to close the year at $155 billion in total assets.
Investors should be no less skeptical when it comes to these products (and indexes) replicating historical returns or outperformance, and how past performance is communicated in marketing material. “Good stories can be crafted out of good back-tests,” said Joel Dickson, investment strategist at Vanguard Group in Malvern, Pa. And, increasingly, as ETPs launch based on such strategies — also including buyback activity, credit spreads or a stronger dollar — even the back-tests occur less frequently.
“It's about the immediate viability of the strategy,” added Mr. Dickson. Sometimes, these strategies are presented without live index data (or a back test) as solutions intended to provide relative outperformance against a standard equity benchmark.
Vanguard found in a July 2012 research report that the outperformance observed in back-tested performance for a significant number of freshly crafted ETPs and indexes “does not persist, on average, past the live-index date.”
While the Financial Industry Regulatory Authority published an interpretive letter to ALPS Distributors last spring regarding the acceptable use of back-tested or “pre-inception index performance” in communications with institutional investors, the marketing on such results for ETPs and ETP-based strategies is still prohibited when directed toward financial intermediaries and retail clients.
And even in institutional marketing materials, caveats abound on back-tested performance data relative to live index data and later, after a product launch, to the actual price and net asset value returns.
In the rapid-fire, first-to-market playing field of exchange-traded products, every data point can offer an edge, even if the cited performance never really existed. With the traditional, market-capitalization-weighted indexes blanketed by ETPs around the world, the newest passive products are launched on strategies more designed to be marketed than to solve for a particular asset class or sector exposure.
Where backfilled results did help, Vanguard observed, was in cash flows to the ETP in the first six months. The institutional safeguard of not investing until observing an independently verified three-year track record for the actual investment product, it appears, isn't necessarily embraced by the broader investing populace when it comes to ETPs.
“You often have to read the footnotes for what's back tested and what's live,” said Tony Davidow, vice president at the Schwab Center for Financial Research in New York. “Is the methodology sound and repeatable? What about the underlying metrics and weightings?”
“Has the index been tracked through rising and falling markets? What about the interest-rate environment? These drills are helpful and instructive, but even then are not absolute,” said Mr. Davidow, who contrasts the views on fundamental indexes in 2005 — when Research Affiliates LLC first published on the topic — to those held today, in which several ETP issuers offer products isolating exposure to several factors beyond market capitalization.
The argument is one that goes beyond academic rigor and into practice.
“Following the initial publication of the paper on fundamental indexes, many people quite rightfully said "this is thoughtful and appears to work very well, but it's all a back test,” said Chris Brightman, head of investment management at Research Affiliates, in Newport Beach, Calif.
The firm's fundamental methodology is now deployed by several index providers for multiple ETPs, as well as institutional strategies for the California Public Employees' Retirement System and New York City Employees' Retirement System, among others.
“Any newly introduced strategy deserves healthy skepticism,” said Mr. Brightman. “Even before the back test, we ask "why would investment markets work in such a way that you would be confident that this concept would persist?'”
“Results that confirm the hypothesis must be robust in a number of different ways, including a test over the longest period of data available,” said Mr. Brightman, adding strategies that work in particular time periods might not work in others or in inflationary/deflationary environments or even across industries and countries. n
