Beware the Back-Test Investment Kings and Their Perfect Hindsight

March 25, 2014 — -- Suppose someone went around telling people that he’d been certain of the Super Bowl’s outcome — that the Seattle Seahawks would roll over the Denver Broncos. With great brio, this person would tick off all of the reasons he was so confident of the Denver rout, which would amount to nothing more than a summary of what happened. The problem with this, of course, is that there would be no proof that he actually predicted the outcome. If he had, he would have bet the ranch on the game; but he didn’t.

Then suppose that he offered to advise you on the likely outcome of next year’s Super Bowl and then place bets on it on your behalf, taking a fee for his services. Would you give him your money?

A new breed of investment advisors selling their management of investments including separately managed accounts, mutual funds and exchange-traded funds (ETFs – pooled investments like mutual funds, but they are bought and sold on exchanges like stocks) is doing basically the same thing. With the benefit of 20/20 hindsight, they cherry-pick the histories of narrow investment categories during set periods and ... voilà: A great performance story emerges.

Of course, this is really a case of woulda, coulda, shoulda masquerading as “look what I did.” The problem for investors, however, is that the material is seldom presented as such. In many of these marketing pitches, there is little indication that the historical data is not real performance data — reflecting the outcome of actual investments by the proud advisors — but nothing more than what market analysts call a back test.

A back test is a look back at a particular type of investment during a set period to get an idea of how it performed under certain market and economic conditions. The goal is to inform current decisions about future investment.

But these advisors don’t make it clear that these presentations involve back tests. Instead, they give the impression that they presciently invested clients’ money in these winning categories. In the most candid of these promotional materials, only amid the gobbledygook verbiage in fine print at the bottom can you learn that these success stories weren’t stories of real investments.

I met one of these advisors at a conference recently. He was bragging about great stock market results in 2008, when everyone else was losing their shirts. Eventually, it came out that he’d been managing no money at all then. He was just talking about his back test.

So these advisors aren’t as straightforward as the guy who wants to place bets for you on next year’s Super Bowl. At least he admits up front that he didn’t have money on the game. And even if he had, this would be no indication of great insight because, in a straight-up bet, he’d have a 50-50 chance of winning.

By contrast, the advisors marketing back tests and real performance aren’t concerned about the odds. By reverse-engineering for investing success, they have a sure thing. If a back test doesn’t work out the way they thought it might, they bury it and look for one that does — a brighter story to use to lure investors. The angle is that you, too, can get equally good returns if you sign up.

Of course, it never worked because no one ever used this methodology; it just looked good theoretically in hindsight. Unfortunately, the investment industry is awash in advisors who must serially change what they’re doing – or just their marketing -- so they have something attractive to sell; their actual records won’t convince anyone.

Many legitimate advisors use back-testing to plan their investment process. They are mindful of the market and economic conditions at the time, and if they believe that back-tested “results” can be repeated, these same conditions must exist. Yet the back-test sellers don’t worry about this one whit. In the markets, as in the NFL, conditions are never precisely repeated. If they were, football wouldn’t be so unpredictable and the markets wouldn’t be the random beasts they are.

So when you hear about an ETF — or any other investment — that has had “results” that are too good to be true, ask annoying questions. And always read the fine print. It may be nothing more than a back test prompted by an historical look at what would have worked, not what did.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

Ted Schwartz, a certified financial planner, is president and chief investment officer of Capstone Investment Financial Group. He advises individual investors and endowments, and serves as the adviser to CIFG UMA accounts. Because Schwartz has a background in psychology and counseling, he brings insights into personal motivation when advising clients on how to achieve their wealth management goals. Schwartz holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at ted@capstoneinvest.com.