Alternative asset management firm Evanston Capital Management has published a whitepaper analysing the return properties of smart beta strategies and how to adjust historical backtest results to inform prospective return assumptions.
The white paper outlines foundational characteristics of smart beta strategies and the impact of data mining and arbitrage on historical backtests when calculating accurate forward-looking return estimates for such strategies. The key identifying assumption for the particular smart betas and time periods analysed is motivated by Nobel Laureate Eugene Fama’s famous 1991 Efficient Capital Markets survey paper (ie Efficient Capital Markets: II). Evanston Capital Management analysed both backtested and actual performance data over a 25-year-period and found that all of the performance metrics decreased during the out-of-sample period. The out-of-sample performance reductions ranged from 30-to-71 per cent, suggesting that data mining and arbitrage play a material, economically significant role in performance expectations.
“Smart beta is one of the most popular, cutting-edge investment products available today,” says Peter Hecht (pictured), PhD, Senior Investment Strategist, Evanston Capital Management. “As is the case with many investment products, the largest risk confronting smart beta investors is what to assume about returns on a prospective basis. Unlike other products, smart beta strategies have a few key features that make predicting returns on a prospective basis interesting, yet potentially problematic. While historical backtests are indeed helpful, we found that without fully appreciating the impact of data mining and arbitrage, the over-reliance on historical backtesting can create a false sense of confidence about future return performance.”
Adam Blitz, CEO and CIO of Evanston Capital Management, adds: “Through our whitepapers and research, our goal is to educate both investors and financial advisors about major issues confronting the markets and provide actionable guidance on how to better navigate the evolving environment.”
