Investor Should Beware Of Back-Tested Results In Marketing Materials

The New York Times provides an example of why investors should not trust strategies that are advertised as successful based on hypothetical returns in prior periods. The example comes from Spruce Alpha, a hedge fund run by Spruce Investment Advisors, which specializes in managing money for the wealthy and institutional investors like the Hamlin School, a private all-girls school in San Francisco, family offices, corporations and pension plans. Spruce "pitched large returns in periods of market turbulence" and emphasized in its marketing materials that the strategy would have generated "outsize[d] hypothetical performance going back as far as 2006." Despite this, Spruce Alpha lost nearly half its money during the market turbulence in August 2008 by heavily relying on exchange-traded funds (E.T.F.s). While it's not clear yet exactly what caused the losses:

The back-tested results for the Spruce Alpha fund may not have taken into account how markets and investors would react given the kind of circumstances that took place in August. The hypothetical results could have underestimated the fact that some E.T.F.s are used as trading instruments that big money managers move quickly in and out of in times of extreme market volatility.

Back tested results are easily manipulated to make an untested investment strategy seem better and less risky than it actually is:

Back-tested results in hedge fund marketing materials have long drawn scorn from some in the hedge fund world. The results are typically recreated with the benefit of hindsight, making it easier for a fund to post hypothetical good results.

Norman Kilarjian, a partner with Aksia, a hedge fund advisory firm to institutional investors, said individual investors should not put great credence into back-tested results in hedge fund marketing material because the results are derived assuming optimum trading conditions.

“I’ve never seen a back-test that didn’t look fantastic, but investors are often falling for it,” he said, not commenting on any specific hedge fund.

There are two takeaways from this. First, regulators should take a hard look at how funds and advisors are using back tested results to sell their strategies to investors. Second, investors should take such hindsight analysis with many grains of salt.