Archives for February 2013

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Beware of Backtested Market-Beating Strategies

As a general rule, if somebody is recommending a given strategy to you as a method for outperforming the market, you should neither be surprised nor impressed to learn that the strategy has impressive historical results.

If you get to make up as many strategies as you want, then backtest them all to see how they worked, you will come up with something that performed well. But that doesn’t mean anything about your skill at outperforming the market. Nor does it mean anything about the likelihood that the historically-winning strategy will continue to be successful in the future.

For example, if an advisor is trying to sell you a portfolio of actively managed funds, you can bet that the funds will have market-beating track records. But, if all we care about is historical results, it would only take a few minutes to come up with a portfolio of 3 individual stocks that beats the pants off the advisor’s active-fund portfolio. Does that mean that, going forward, the 3-stock portfolio is a better bet than the advisor’s mutual fund portfolio — and that both options are a better bet than an index fund portfolio? Of course not.

What if there is a convincing explanation for the historical data?

Consider the following piece of information:

Fund manager age and fund performance have a significant positive correlation. (On average, for each additional year of age, performance improves by almost 0.09%.)

Interesting isn’t it? That’s a sizable difference. And it’s easy to think of reasons why this effect might not be purely random (e.g., older managers have wisdom that comes with age, they have more developed social networks that allow them to get information more quickly, etc.).

Well, guess what?

I lied. (Please forgive me; I’m trying to illustrate a point.) According to the only study I’ve found on the topic, it’s actually the younger managers who tend to have better performance. And now that I’ve told you that — despite it being the exact opposite of what I said above — it’s still easy to come up with a credible-sounding explanation (e.g., younger workers have more energy and motivation to get ahead in their careers, they’re more up-to-date with various useful technologies, they’re more willing to take risks, etc.).

By definition, even if it’s the result of pure randomness, some age range is going to have the best-performing fund managers. And no matter what age range it is, our human brains will have no trouble coming up with an explanation for why that phenomenon makes sense and why it could be expected to continue.

As humans, we look for patterns. And when we find one, we try to identify a cause — even when there’s no cause to be identified. We’re naturally susceptible to being “fooled by randomness.”

Maintain Your Skepticism

If a person has anything to gain by convincing you of his ability to beat the market (e.g., a commission, your assets under his management, or your subscription to a paid newsletter), it would only be surprising if he did not have a strategy with impressive historical results and a convincing explanation.

Short-Term TIPS Fund vs. Intermediate-Term TIPS Fund

A reader writes in, asking:

“Could you share some thoughts on how the original Vanguard TIPS fund compares to Vanguard’s new short-term TIPS fund? For example is the inflation protection for both funds roughly the same? What about interest rate risk?”

Costs

As far as costs go, the funds’ expense ratios are almost identical. One slight difference is that the short-term fund offers Admiral shares starting at $10,000 while the regular TIPS fund has a $50,000 minimum for Admiral shares. (Though if we’re talking about amounts less than $50,000, a 0.10% difference in expense ratio is at most a difference of $50 per year — not really enough to worry a great deal about.)

Inflation Protection

All TIPS (whether shorter-term or longer-term) have their principal adjusted in keeping with the Consumer Price Index for All Urban Consumers (CPI-U). As a result, both bond funds should offer the same degree of protection against inflation.

Yields and Expected Returns

The short-term TIPS fund will earn lower returns over most periods of time because shorter-term bonds have a lower yield than longer-term bonds. For example, as of this writing, the short-term TIPS fund has a yield of -1.60%, and the intermediate-term TIPS fund has a yield of -1.10%.

It’s important to note that neither of these yields include the inflation adjustment that the TIPS will receive over time. For example, if inflation was 3% over the next year (and real interest rates didn’t move), the short-term TIPS fund would earn a nominal return of roughly 1.4% (that is, -1.6% plus 3%), and the intermediate-term TIPS fund would earn a nominal return of roughly 1.90% (that is, -1.10% plus 3%).*

Interest Rate Risk

The regular TIPS fund has an average duration of 8.5 years, whereas the short-term TIPS fund has an average duration of just 2.5 years. As a result, the share price of the short-term fund will fluctuate considerably less — less than 1/3 as much — as a result of changes in market interest rates.

Conclusions

In short, choosing between a short-term TIPS fund and an intermediate-term TIPS fund is much like choosing between short-term and intermediate-term nominal bonds. That is, if you can’t handle the price volatility that comes with intermediate-term bonds, you’ll want to use the short-term fund. And in exchange for that reduced volatility, you can expect to earn less per year (in this case, about 0.5% less).

Or, if you are convinced that real (that is, after-inflation) interest rates will rise in the near future, you might want to use the short-term fund. (Though, again, you’ll be earning about 0.5% less per year while you wait for rates to rise.)

*This is an approximation. To get the exact return figure for an individual TIPS, you need to do a calculation every 6 months (because TIPS pay interest twice annually) wherein you multiply the existing principal by inflation over the previous 6 months, then calculate the appropriate amount of interest (i.e., 50% of the annual interest rate).

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