July 25, 2012
--- Exchange-traded fund
(ETF) providers compensate for the lack of live data on new funds by using an
index’s back-tested data to predict performance, a report found. ---
Vanguard’s study, “Joined at the Hip: ETF and Index Development”
found that these estimates are often unreliable. While 87% of the indices outperformed the broad U.S. stock market for the time in which back-tested data
were used, only 51% did so after the index was launched.
Past performance data is not necessarily indicative
of future results, but investors are making investment decisions based on this
nonetheless. Joel Dickson, one of the study’s authors and a principal in
Vanguard’s Investment Strategy Group, said that he thinks this decisionmaking
strategy is a mistake.
“I think there’s too much rearview mirror
investing,” Dickson told PLANADVISER. “Nobody would suggest driving your car with a rearview
mirror because you’re going to run into the wall that’s right in front of you.”
In investing, that wall is underperformance, which
many ETFs experience after an index goes live.
The performance of the 370 indices
against the total U.S. stock market might look strong at an annualized excess
return of 10.31%—but that percentage is based on back-filled data. After the
index-live date, the performance of the indices was an annualized excess return
of -0.93%—less than that of the broad U.S. stock market.
This raises the question: Why does the performance
before the index-live date look so strong?
The reason for this is ETF makers are “cherry-picking”
the indices that have recently performed well to track.