I recently had a deep conversation with an experienced financial advisor about the backtested performance of a couple of model portfolios that were presented. He mentioned to me that the performance looked really attractive, including one model that showed backtested performance of no negative annual returns for several years. He was really excited about this backtested performance. I was much more skeptical as they were just backtested performance numbers, without any real context of the drivers of that performance.
I have been pitched new investment strategies throughout my career with hypothetical backtested results that looked really good on paper. I have yet to have been presented an investment strategy that had poor backtested results. Selling backtested results is a sales strategy on both an institutional and retail investor perspective.
Let’s focus on the average retail investor and how they are constantly shown backtested results based on investment proposals by financial advisors.
Using easily available financial advisor client investment proposal tools, to show great backtested performance to “sell” a client, all an advisor needs to do, is find the best performing “5-star” mutual funds, ETFs, stocks, etc. that performed very well over the last 5-10 years, plug these investments that outperformed the market into the client proposal tool, and state: If you would have invested in these positions in this allocation, you would have made X% a year with less risk than the market. Then, when the client gets excited and gives the assets to the advisor, the advisor’s sales pitch is over.
ANYONE with an investment proposal tool (there are free ones out there, i.e. Morningstar.com, etc.) can create an “awesome” backtested portfolio. Based on my experience, what has worked in the past was based on certain investments styles that were in favor during that period (growth vs. value, defensive investment vs. aggressive investments, etc.) and that investment style may not persist going forward.
So, when the backtested portfolio proposed by the financial advisor does not perform in the way it did in the past, the client gets a bit annoyed, so the financial advisor creates a new proposal based on new backtested performance and “sells” the clients tweaks to their investment account. Wash, rinse, repeat.
Historical Performance/Morningstar Ratings
A lot of mutual fund investors will choose investments based on Morningstar star ratings and/or rank in category. Those star ratings and rank in categories are based on what happened in the past. Throughout my career, I have seen 1 star funds, turn into 5 start funds, just based on the investment manager’s investment style being out of favor the last 3-5 years, then being favored. I have also seen mutual funds go from a 5-star fund to a lower star fund just based on Morningstar changing the category that the fund is assigned. One day its a 2-star fund, the next day Morningstar assigns a new category to the fund, and it becomes a 5-star fund. It’s that simple.
Think about the markets today. Over the last 5+ years, aggressive, growthier managers materially outperformed the “boring, steady-eddy managers” and the aggressive managers looked great on paper based on their past outperformance. Starting last year, more aggressive areas of the market started to decline materially. As aggressive portfolios with 5 star Morningstar ratings and top ranks in categories looking back the last few years started to significantly underperform during this year’s market selloff, those 5 star ratings and top rankings started to shift to 3 star funds and bottom rankings. Conversely, those conservative, boring, steady-eddy investment strategies that were 2-star and/or low rank in categories a couple of years ago, they are now showing to be higher star ratings and better rankings, as they have materially outperformed the more aggressive strategies.
Based on my experience, these shifts in Morningstar star ratings and rank in categories often shift to looking bad to good and vice versa, roughly every 3-5 years. They tend to go in cycles. From my perspective, whenever I look for an investment manager to allocate to, I’ll generally prefer those strategies that are currently low in star ratings and/or rank in categories that underperformed the last couple of years, that have the potential to outperform over the next few years.
Summary
In summary, using backtested or historical performance as a guide to making investment decisions aren’t as clear cut as one would seem, and one should be extremely skeptical. You need to focus on the drivers of what is making those backtested results to be what they were to determine whether or not those drivers/factors can persist into the future. DO NOT just rely on backtested or historical results based on face value, as your expectations would most likely not be met and you will continue to chase your tail finding the best backtested/historical results ever few years. That’s generally not a great strategy.