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Hypothetical is Industry Code for Hogwash

Don’t use hypothetical track records

I can remember a call from years ago as if it was yesterday. One of our investors had decided to move all their Potomac accounts to another firm. This is part of life in the investment industry and for any business, when a client leaves, it can be a tremendous learning experience.

Why did this client move his business?

Customer Service? Maybe, but Potomac has the best customer service in the business!

Technology? Possibly, but we punch above our weight class and can hang with the big boys.

Performance? Perhaps, because as all parents know you can easily distract toddlers with a shiny new toy, as was the case here.

During our exit interview, the client told me about the great performance figures from the new firm. "Manish, this firm has double-digit annualized rates of return with minimal drawdown for over 20 years!"

I was intrigued and excited for him, but most of all very skeptical because the S&P 500 has twice experienced drawdowns of roughly 50% in the last 20 years.

Also, the person in my head (my dad) is screaming, "If it's too good to be true, then you can bet your ass it isn’t".

It was time to investigate! First let’s look at the differences between “real” and “hypothetical” track records.

How are “real” track records created and maintained?

A “real” investment management track record are the results from actual client accounts. This means a client likes your investment philosophy, signs a contract, pays you and you begin to manage their assets as a trusted fiduciary.

Over the years, if you are lucky enough, you will gain more clients and continue to track the results of each account. If you report these results the SEC mandates that you have actual account statements from a third party custodian that can validate your performance calculation.

Although not required you can also take this a step further by hiring an unaffiliated firm to complete an audit of your performance results. The industry gold standard for audited performance is run by the CFA Institute and is called the Global Investment Performance Standards (GIPS). While not perfect, it is quite expensive and at least assures some standards when it comes to performance verification.

If you are curious about the firms that claim compliance the CFA keeps a list of firms that adhere to these performance standards.

How are “hypothetical” track records created and maintained?

I have tested, tweaked and created hundreds of trading systems since I started in this business. It is common practice to back-test various indicators to see how they reacted under certain market conditions.

For example, let's take a simple moving average crossover indicator used by portfolio managers, but mostly just talked about by cable news bobbleheads, called the Golden Cross.

You can create a formula that buys the S&P 500 when it’s 50 day moving average goes above its 200-day moving average, and then sells it when the reverse happens. Plug in some historical data and with a few clicks on a computer program, you can have a track record of hypothetical performance results.

A money manager can back-test various indicators, create a track record and then actually sell this performance to clients.

The kicker is, this is all a legal and accepted practice, even though the tide may be changing with recent SEC enforcement.

Here is the skinny: None of the performance happened. They are results that have been back tested using a computer program. No actual clients were used, or capital put to work.

Creating an investment strategy based on “what ifs” and looking backwards, does not mean that the future will hold the same success.

As time has repeatedly proven, “hindsight is always 20/20.”

To spot the charlatans, the dirt is in the disclosure

Almost every investment strategy has a fact sheet, which displays the risk and performance of the strategy as compared to a benchmark. If you know what to look for, a strategy fact sheet can reveal a lot about how transparent the money manager is and what could be hiding in the closet.

I asked the client to send me a sample performance fact sheet for the new firm that I could review. Because I have been in this business most of my adult life, I knew to skip all the performance information and head right for the bottom of the page.

Why? Because quite frankly, the "dirt is in the disclosure."

It didn’t take long to find what I was looking for. A couple of lines into the small print, the disclosure read "Performance prior to 12/31/15 is hypothetical."

The performance that was being reported was going back to 1993 BUT actual client accounts didn’t start until 2015!

To prove my point, I decided to create my own hypothetical track record.

So, I huddled with my team. Let’s create our own hypothetical track record.

Blank Stares…

I explained that we are not going to make this an actual strategy but for the purpose of this exercise let’s assume that we are going to release this to the public.

In other words, lets run an actual back test, create a strategy profile and then have a fact sheet designed. I believed this would clearly demonstrate the ridiculousness of hypotheticals.

So, we started off building the fact sheet…

Investment Strategy:

Potomac DUH Growth Strategy (DUH stands for “Don’t Use Hypotheticals”)

Objective:

The objective is to demonstrate to investors the inherent malarkey that permeates the presentation of hypothetical performance numbers. Furthermore, we encourage investors to begin their review of any investment vehicle by first reading the disclosure. 

  • Real managers have real track records using real accounts.
  • Real managers go through tough times but rather than create new hypothetical performance that is tied to a small period of actual performance, they stand by their existing real track record.

Strategy Description:

The Potomac DUH Growth model was created in a total of 30 minutes. We took some of our computer models and entered in the date range we desired in addition to the trading vehicle. With a few clicks of a mouse, voila, we have an unbelievable track record that isn’t even worth the paper it is printed on. This is how almost every single hypothetical track record is created. Someone will back test certain trading indicators, start trading it and then attach a very small actual track record. Maybe you could have possibly, maybe, sort of, kind of achieved this or similar results if you were a hypothetical person that lived inside of our computer. Maybe!

Prospective Client:

No one should ever invest in a portfolio that reports hypothetical numbers!

Performance Chart:

Don’t use hypothetical track records

Historical Performance:

Don’t use hypothetical track records

Disclosures:

We compiled a list of disclosure language that was pulled from actual hypothetical fact sheets and couldn’t resist adding our own commentary.

Don’t use hypothetical track records

You can check our finished product, Potomac’s DUH Growth Strategy fact sheet here.

Because of the world we live in I must remind everyone that this is not a real investment strategy, and this is not investment advice. This is totally, 100% made up nonsense for illustrative purposes only.

Conclusion

Imagine if you could go back and give your high-school self some advice. There is not a single person who doesn’t have a regret or two that they wish they could rectify if only they could go back in time. Well, we can't do that, so most of us just live with those regrets and move on.

Some money managers, however, live in an alternate universe, where they can go back in time and never live with investment regret. They do it all the time by creating hypothetical track records.

You would think there’s a pony in that pile of poop. But, it’s just a pile of poop!

At Potomac, we strongly believe, as we stated before:

  • Real managers have real track records using real accounts.
  • Real managers go through tough times, but rather than create new hypothetical performance that’s tied to a small period of actual performance, they stand by their existing real track record.

When evaluating investment managers, make sure to review the disclosures on the fact sheet, and look for performance based on actual accounts and not imaginary clients.


Disclosure: This information is prepared for general information only and should not be considered as individual investment advice nor as a solicitation to buy or offer to sell any securities. This material does not constitute any representation as to the suitability or appropriateness of any investment advisory program or security. Please visit our FULL DISCLOSURE page.