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Beware the Backtest

Backtesting is a popular tool amongst traders and marketers. Traders use it to experiment and uncover new strategies. When one looks promising, the marketers go to work! Creating fancy charts and graphs to sell you on hypothetical performance. But are strong backtests indicative of strong future results?

The world of "Smart-Beta" is filled with promising backtests. Unlike plain-vanilla ETFs that simply track an index, Smart-Beta aims to outperform by adjusting their holdings - sometimes greatly deviating from their index. 

A recent study called the Smart Beta Mirage analyzed the performance of these "smarter" funds from 2000 - 2018. Sadly, it found that outperformance only lived in the data. 

Smart-beta in backtests showed an above-market returns of 2.77%, but when put into action, they underperformed by 0.44%.  

There are several reasons for the disappointing results. The most obvious one, no one can predict the future. The oldest adage in investing is "Past performance is no guarantee of future results". Things change, what worked in the past might not work in the future.

Another reason is backtesting is flawed. It's susceptible to bias and data mining. ETF providers are incentivized to attract as many investors as possible. A great way to do this is to show great performance would've been, even if it sacrifices the integrity of testing. 

While backtests are interesting and a great tool if used correctly, like star ratings and analyst targets, they do little in predicting the future. Don't count on them. 


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