There are lies, damn lies, statistics…and then there are backtests.

Isn’t it crazy how every sales guy working at an investment firms claims their products/strategies consistently beats the market? You’ve never heard a salesman say “To be honest, most of our clients lose money with us. However, our client portal is, modestly speaking, quite exquisite.”

However, it’s critical to pay particular attention during these sales meetings and impressive performance with the distinctions between true actual performance, model performance and back-tested performance. Occasionally you will run into a sales rep that claims his performance is GIPS compliant. That means his/her firm uses performance data that only contains actual portfolios managed by their firm. GIPS stand for the Global Investment Performance Standards and are a set of voluntary guidelines for calculating and presenting investment performance. Just because a firm is GIPS compliant doesn’t mean they their performance isn’t misleading. I’ve seen GIPS compliant firms use selective periods in a brochure that only highlight the periods of outperformance, which makes it hard to compare to other options. Instead of getting performance in 1,3,5,7, & 10 year time periods you will get performance in 1 year, 3.67803 years, 5.478 years, and since Breaking Bad Season 2: Episode 6.

Traditionally, an advisory firm will use a model portfolio to show hypothetical or simulated performance. The model is often presented as an ideal combination of securities for a client’s portfolio. Unlike the model portfolios, back-tested performance presents hypothetical results based upon the retroactive application of an adviser’s investment strategy over a select market period. If it did poorly, you and I will never see it. They know it will never sell. But if it looks good, then it might end up in my inbox. The joke in the industry is that you’ve never seen a bad back-test and you will never see one. Investors should always take back-tests with a massive pinch of salt. When dealing with back-tested performance from potential investment managers, ideally, I’d like to see 5+ years of live results and 30+ years of back-tested data. That increases my confidence that there’s really something to this new idea.

In all cases, though, the hypothetical performance data would be misleading unless it is accompanied by full and clear disclosure explaining what it is, how it was derived, why it is being provided, the fact that it is not the performance of any actual account and, of course, that it is not a guarantee of future results. Unfortunately, there is no such thing as a front-test because there is no cure to for those who wish to mislead, or fools who wish to part with their money.

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