A. Before you jumping in, imagine the following -
You want to manage money using a quantitative, momentum-based investment strategy that is all the rage with today’s investors.
You have hired a fabulous quantitative analyst in the past year who has been tinkering with several investment models that would have delivered excellent returns over the past ten years based on back-testing the results.
You are allowed to publish those completely fictional returns as supplemental information as long as you disclose to investors that the returns are fictional… or supplemental.
You then put together a glossy, five-page marketing brochure which shows how you neatly sidestepped down markets over the past ten years and earned investors fabulous returns with little risk.
The supplemental track record is in large, bold print with multicolored explanatory graphs.
The disclaimer showing the actual six-month Global Investment Performance Standards (GIPS) compliant track record and the statement that the large print multi-year track record is hypothetical and back-tested is found in very small print at the bottom of page five.
You then hire a sales force that does a terrific job of simplifying the “complex,” “proprietary,” and “scientific” investment process behind the amazing returns, using language effective with investors yearning for mystical success in dangerous markets ...
and you raise a few billion dollars of assets under management before launch.
This is a terrific way to make a living… except for the fact that you never actually managed money using the fictional strategy!
Institutional investors avoid hypothetical back-tested returns like the plague. They know that investing in a strategy that is only successful in the rear-view mirror is completely different than investing with a money manager who earned their returns in “real-time.”
It turns out that quantitative investment strategies are notorious for working until they don’t work anymore.
The typical reason that quant strategies stop working in real-time is that other investors see what is working in the market and arbitrage away any excess returns by piling into the same strategy. In many instances the quant model is tinkered with and changed after short periods of underperformance. Or, the money manager simply “overrides” the model when it inevitably stops working in untested or unprecedented market conditions.
As a student of rhetoric and persuasion, I know that long columns of performance numbers, coupled with colorful charts and graphs can be very persuasive. I wonder if consumers of investment management who are desperately trying to make an informed investment decision are aware of just how misleading the numbers can be. And, I wonder when consumers will be educated enough to avoid comparing our actual, GIPS compliant track record of performance earned in real time and with the same analysts that we employ today, with fictional returns based on “too good to be true” back-tested nonsense.