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July 21, 2012

Forget the disclaimers. The fund industry’s most persuasive marketing tool is past performance. That puts newly-launched funds at a distinct disadvantage — unless they are exchange-traded funds, that is. Many of the indexes tracked by ETFs offer back-tested data, which is, a measure of how the index would have performed throughout history, had it been in existence.

But here’s what fund companies can do, says Mike Castino, director of index services at Zacks Investment Research. If I’m an ETF salesman, I can say, ‘We just launched the FLAX fund, and I can’t talk about performance, but if you go to FLAX indices, they’re unaffiliated with us, and they have data you can look at.’

He’s not offering literature, and he’s not making promises. He’s just letting the prospective client know that the data are out there. And, by the way, here’s where you can find it.

New research from Vanguard shows that pitch has been an effective one. The firm compared average cash flows into two categories of ETFs: those tracking an index with back-tested data, and those tracking an index without back-tested data. In all asset categories except for fixed income, the ETFs tracking the back-tested indexes gathered more investor cash in their first six months than those without. Absent real performance, investors seem to find hypothetical returns a convincing substitute.

At first glance, it may be hard to see why chasing fake performance is any different than chasing real performance. Defenders say that back-testing, when done fairly and comprehensively, can shed light on an investment thesis over a period of time, or at specific times of stress. As for its predictive value, it may be no more or less valid a bellwether than true historical returns.

No, the problem is more subtle. It has to do with the way ETFs are created. SEC rules make it relatively easy to create an ETF, as long as it tracks an index. An actively managed fund can tout superior analyst research or a manager’s stock-picking acumen. An ETF has to hitch its star to its index — the more unique, the better.

That’s encouraged ETF companies to seek out new and different indexes. Today there are more than 1,400 ETFs on the market, tracking more than 1,000 different indexes. There are at least 20 different approaches to weighting and 27 different selection criteria for indexes tracked by ETFs. A decade ago, all but a few of the ETFs on the market weighted companies by market value. Today almost half use a different criterion.

IN THE SEARCH FOR THE NEW and different indexes that will power a new and different ETF, back-testing plays a critical role. Index providers, including S&P, Dow Jones, MSCI, Russell, Zacks and others can index just about anything. You want to rank the companies in the S&P 500 by earnings growth, then take the 50 top firms and weight them equally? Weight them by market capitalization? Go long the top 50 and short the bottom 50? They can build it. And then they back-test it. Indexes that look good in hindsight have a shot to become ETFs. Those that don’t, don’t.

That approach allows fund companies to cherry-pick, in order to launch funds that can appear rosy. The problem with that, says Joel Dickson, senior ETF strategist at Vanguard, is that there’s no guarantee that the parameters and rules that would define an index you would create today would have been the same ones you would have used, say, five or 10 years ago.

In 2008, you might construct an index that was tilted more toward value factors, Dickson says. And the back-test would show terrific outperformance. But in 2001, you would never have tilted toward those value variables in the same way.

Nor has hypothetical past performance been an indicator of future success. Vanguard’s research shows that the average back-tested index outperformed the market by 10.3% per year in the five years prior to an ETF’s launch, then underperformed by 1% a year in the subsequent five years.

Of course, Vanguard, which will release its research paper on ETFs and index creation on July 23, has its own dog in this hunt. The firm manages $922 billion in passive equity indexes — $209 billion of which is in ETFs — all of the cap-weighted variety; and it has been an outspoken opponent of other kinds of indexes. Traditional indexes can never promise outperformance, which makes them vulnerable to funds that promise a better mousetrap.

Still, back-testing is at best a flawed way to evaluate the merits of an investment, both for the fund companies searching for new ideas to sell and investors looking for market-beating returns. It plays to investors’ worst tendencies to chase yesterday’s best ideas.

Everybody loves a winner — even a hypothetical one.

All Rise

Equity funds enjoyed average weekly inflows of $1.2 billion in the four weeks through Wednesday, according to Lipper. Taxable-bond funds saw $4.3 billion in average weekly inflows; muni funds, $917 million, and money funds, $798 million.