The Rise of Hypothetical Back-Tested Performance

by Travis Morgan, CFA, CIPM

Just within the past few years the use of back-tested performance has seen a spike in usage.  We have begun to see more and more firms rely on this method to create historical track records for marketing purposes.  There are a lot of investment managers out there that rely on quantitative analysis for their stock selection and argue that the historical back-tested track record does materially reflect what their ongoing process would entail.

Technology is constantly improving and as a result becoming less costly.  As a result, more investment managers are able to use technology and the idea of “big data” to come up with creative new stock selection strategies.  They can imagine different quantitative measures that they feel are appropriate and easily test their hypothesis historically to see how the strategy would have performed in different market environments. They are able to make adjustments to see what would have worked best and attempt to use that process on a go-forward basis.  In the past this process would have proven to be very costly and timely for managers to go through.

Another factor to consider is the rise of ETFs.  Over the past 10 years, the availability and the diversity of these vehicles has increased and made it easier for managers to focus on a handful of different ETFs within their models rather than try to diversify their strategy through the use of individual securities.

There is obviously a lot of concern from compliance departments when it comes to back-testing.  Back-testing has fallen under a negative light over the past few years and most firms would rather stay clear of it as a result.  With that being said, with appropriate disclosures and robust methodologies, a firm should be able to market the performance with confidence.  Additionally, our clients have indicated that there is receptivity to model performance on the part of their prospective clients especially when the calculation methodologies have been examined by an independent CPA firm, like Ashland Partners.  We provide model examinations with an opinion letter that attests to the calculation methodologies being used, that industry best practices are being followed, and that the appropriate disclosures are included in any marketing materials.

Please feel free to contact our Client Relations Group if you’re interested in obtaining more information about this type of examination.

 

CFA® and CIPM® are registered trademarks owned by CFA Institute.

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