Vanguard Principal Advises Against 'Rearview Mirror Investing'

July 25, 2012 ( - Exchange-traded fund (ETF) sponsors are compensating for the lack of live data on new funds by using an index’s back-tested data to predict future performance, according to a report.

By Jay Polansky | July 25, 2012
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Vanguard’s study, “Joined at the Hip: ETF and Index Development,” found that these estimates are often unreliable. While 87% of the indices outperformed the broad U.S. stock market for the time in which back-tested data were used, only 51% did so after the index was launched.

Past performance data are not necessarily indicative of future results, but investors are making investment decisions based on this nonetheless. Joel Dickson, one of the study’s authors and a principal in Vanguard’s Investment Strategy Group, said that he thinks this decisionmaking strategy is a mistake.

“I think there’s too much rearview mirror investing,” Dickson told PLANSPONSOR. “Nobody would suggest driving your car with a rearview mirror because you’re going to run into the wall that’s right in front of you.”

In investing, that wall is underperformance, which many ETFs experience after an index goes live.

The performance of the 370 indices against the total U.S. stock market might look strong at an annualized excess return of 10.31%. But that percentage is based on back-filled data. After the index-live date, the performance of the indices was an annualized excess return of -0.93%.

This raises the question: Why does the performance before the index-live date look so strong?

The reason for this is ETF makers are cherry-picking the indices that have recently performed well to track.