By Michael McDaniel, Chief Investment Officer
Few words in the English language carry worse connotations than the term “backtested.” As an investor, I have first hand experience trusting backtested strategies.
I can clearly recall the painful decision to purchase a managed future strategy that touted non-correlated, low risk, consistent positive returns over decades of backtesting (launched in 2007 and still trades below its IPO price), or the tactical strategy that offered above market returns with considerable less risk.
The challenge with backtesting? Because the object is to “find a strategy that works,” the backtester simply iterates the strategy until they find a random sequence that happens to have worked in the past, and then they project that it will work in the future.
It’s almost as if no one had ever coined the phrase “hindsight is 20/20.”
Don’t get me wrong. Backtesting a strategy to see how it might have performed in the past can be very valuable. But developing and choosing a strategy based on how it performed in the past is simply not a sound approach to investing.
Nitrogen covers over 200,000 investments, ranging from US stocks, ETFs, mutual funds, variable annuity subaccounts, SMA strategies, alternatives, UITs, CITs and more.
One of our core values is objectivity. We believe that investors are best served by answering questions objectively and mathematically with data. When in doubt, we will always do the right thing and err on the side of safety.
As a result, our portfolio risk analysis has always required the use of actual trading data to determine the probable risk of those 200,000 investments.
On a few occasions, we’ve had advisors take our methodology to task when it pertained to our analysis of F-Squared SMA strategies, particularly the F-Squared AlphaSector Rotation Strategy. One advisor told us flat out “Nitrogen shows higher risk for F-Squared than I believe it really entails.”
As it turns out, objectivity won yet again. The actual trading data for F-Squared’s strategy was a far more accurate reflection of its risk than the backtested results. Backtested results that, as it turns out, might have been completely fabricated.
While backtesting can be a positive tool for analysis purposes, we believe it has very limited usefulness in real world risk assessment. Advisors can count on us continuing to follow our objective approach that has served them well over many years.