The universe of ETFs (exchange traded funds) has exploded over the last 6 years. In 2007 there were just 500 of them. Now that number is over 1,500 with $1.5 trillion in assets. The question is, how do those 1,000 new funds attract new investors, since they don’t have a track record? The answer is backtesting.
Virtually all (so far) ETFs track an index of some kind. Some of them are pretty common, like the S&P 500. And some are much more obscure, tracking things like the BRXX Brazil Infrastructure Index. That opens the door for companies to make deceptive claims about performance. When they advertise their new fund, they may show a chart of how wonderful the index has done in the past. But there are two problems with that. First, of course is the famous “past performance is not indicative of future results”, which is very true. But it’s worse with these funds. The fund probably did not exist over the period indicated. So they are not even showing a fund history. They are showing a hypothetical fund history. It’s kind of like artificial margarine is two steps away from real butter. This is two steps away from actually telling you what might happen with your investments. They use backtesting of historical data to show what has happened and imply that it may continue in the future.
I don’t much care for this practice. It’s another example of Wall Street using deceptive practices to sell a product. Don’t get me wrong, I think ETFs are a great invention for passive investing. But using backtesting to imply a particular outcome is just wrong. If you’re looking at buying an ETF, make sure that you’re getting the straight story about what the fund has done, and not what they wish they had done, with their backtested data.