Yesterday I posted about Jason Zweig’s recent article, that discussed a manager’s questionable past performance that was being shown to prospects; it was based on backtested results.
Rick Ferri wrote a Forbes post that also discussed this manager. He discusses at length the potential problems with backtesting. He suggests that the “problem is that most individual investors do not understand that they’re looking at hypothetical returns even if the required disclosures were written clearly and put in plain view. People tend to not read the fine print − they go right to the numbers.” I don’t disagree with Mr. Ferri. This is one of the reasons GIPS(R) (Global Investment Performance Standards) prohibit linking hypothetical (e.g., backtested, model) results to actual, where “linking” refers to “Presentational Linking: To be visually connected or otherwise associated within a COMPLIANT PRESENTATION (e.g., two pieces of information are LINKED by placing them next to each other).” (See The Supplemental Information Guidance Statement).
The only issues I have with this post stem from the following statement: “My solution would be an SEC directive that prohibits advisers from using backtested returns in any marketing material. If [a] firm does not have Global Investment Performance Standards (GIPS) results, then they cannot publish performance. That’s clean and simple.”
First, is he recommending mandatory compliance? It appears so. At least for anyone who wishes to report past performance. Since we are working with BrightScope and a board of advisors to develop a separate standard (UAPS: Universal Advisor Performance Standards) for those who cannot comply with GIPS, I obviously take exception to this. Second, it appears he is implying that with GIPS backtesting issues will go away; but they will not. GIPS permits it. Of course, if the SEC does prohibit it, then registed SEC firms would be required to follow these provisions, though firms who don’t fall under the SEC’s regulations could continue to do so.
I don’t follow how backtesting going away means that one must follow GIPS.
Backtesting can serve a useful purpose. There is no cure to those who wish to mislead, or fools who wish to part with their money.