Backtesting Performance Failure

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One area of performance advertising that the Securities and Exchange Commission has given great scrutiny, but not banned, is using backtested performance. Since, backtesting only shows theoretical past trades, it does not involve market risk. That means it’s inherently suspect. You can just keep fine-tuning the model to maximize results, with no ability to carry that forward to maximize returns going forward.

The SEC delivered a Christmas enforcement present to F-Squared Investments and its co-founder Howard Present for failures with back-tested performance.

There were two failures. One was that F-Squared failed to disclose that the past performance advertised was based on back-tested performance and not actual trading. Second, the past performance was incorrectly calculated. In reading the settlement documents for the case it looks like the problem originated with the data sources for the F-Squared AlphaSector index. It relied on a third-party data provider to generate the trading models.

F-Squared advertised that $100,000 invested on April 1, 2001 would have been worth $235,000 on August 24, 2008.

There were two problems with that statement. F-Squared was not in existence until 2006 and did not use this trading model until 2008. F-Squared failed to disclose that the performance was based on backtested performance.

The second problem was that the calculation was incorrect. In compiling the past performance the data provider was off by a week on each trade. That actual performance would only have been $138,000 if the past performance was calculated correctly. (Merely taking the broad bet by investing in S&P 500 ETFs would have resulted in $128,000.)

According to the complaint, Mr. Present tried to get better back up for the past performance methodology. That arose again during a 2012 mock audit. When he sought the information again, he discovered that the data model was created by a 20 year old former intern who would have only been 14 in 2001. It was at that time that Mr. Present discovered the dating problem with the past performance.

The SEC has not come out and said the backtested performance is not allowed by investment advisers and fund managers. It has addressed the issue in at least four other enforcement cases. In the F-Squared case, the SEC did not say that the backtesting was by itself was fraudulent, deceptive or manipulative. It was the incorrect calculations and disclosure failure that was fraudulent, deceptive or manipulative.

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