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The Latest ETF Eye-Opener

August 31, 2012

Magnifying Glass

A few years ago, we discussed the flow of money rushing into ETFs without careful analysis by investors about the unknown risks.

Institutional Investor recently highlighted another downside to these investments: ETFs’ use of hypothetical, back-tested performance. To attract assets, some index providers have unique indexes based on various performance characteristics, weighting methodologies and valuation metrics. They then launch an ETF and tout the investment’s theoretical performance.

A new study by Vanguard warns that this may be misleading to investors. Of the indexes that the firm analyzed, 87 percent outperformed the broad U.S. stock market during the time in which back-filled data were used. However, “only 51 percent did so after the index was launched.”

This may mean that there may be some selection bias built into the hypothetical results based on what worked in the past, says Institutional Investor. Regardless of the reason, once these funds were implemented, the real-time performance diverged from historical results.

To complicate matters, it isn’t “readily apparent” for investors to decipher which indexes have been around for years and have a demonstrated track record versus ETFs that tout indexes based on fill-in-the-blank historical data. Institutional Investor says sources including Morningstar show an inception date that could be a “back-filled period.”

This use has received the federal stamp of approval. According to the magazine, “The Financial Industry Regulatory Authority bars most fund owners from using back-tested data to promote their products. But index providers are not subject to that restriction.”

In our view, no hypothetical data could replace the historical performance generated by day-to-day, real-time decisions about real assets during bull and bear markets. To paraphrase Warren Buffett, investors might want to beware of ETFs bearing back-dated results.


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