There are currently more than 70 times as many stock market indexes as there are actual stocks, according to a study by the Index Industry Association, and over 3 million indexes covering the stock markets in total. As the number of these indexes grows, so too does the need to protect investors from misleading information regarding their past performance and expected returns.
We have indicated previously how firms can (and often do) create back-filled indexes from scratch. Indeed, there’s an undeniable temptation to create indexes that show tremendous albeit unrealistic past returns, akin to formulating an index of only stocks that “went up.” When asset managers create and market such indexes, investors may be misled into expecting their actual funds to match the hypothetical, highly-curated past returns. Since these products can be created and published with minimal disclosure or policing of underlying information, one wonders when and how the SEC might get involved to protect investors (our suggestion: soon).
The following examples in the growing “risk premia” liquid alternatives space show how such indexes can mislead investors and support an argument for more and stronger SEC regulation.
PowerShares Multi-Strategy Alternative Portfolio Fund
As we discussed in more detail in a previous article, the PowerShares Multi-Strategy Alternative Portfolio Fund (LALT) was launched in May 2014, seeking to match or outperform a separate, newly created index of hedge fund-like trading called “risk premia” strategies. Since the SEC strictly regulates the reporting of back-tested or hypothetical fund performance, the objective here was to create an “index” of those same trading strategies—in which the back-tested “index” figures are essentially equivalent to the hypothetical “fund” performance but with far fewer disclosure requirements.
In describing the “historical” performance of the fund prior to its launch, LALT used 10 years of backfilled data to show what appear to be enviable returns. If “live,” the index performance—90 percent of the returns of the S&P 500 with 20 percent of the volatility and a maximum drawdown of only 2.4 percent—would have ranked it among the most impressive 10-year stretches in performance among any active managers (in fact, among the top 1 percent of hedge funds). Placed alongside the marketing material of a newly launched fund, it could be expected to dazzle investors whether it was remotely realistic or not.
The danger for investors in relying on such backfilled information to predict future actual performance was made clear when LALT went live in 2014. Since that time, the fund has not only failed to replicate the lofty returns its hypothetical “track record” would have predicted, but it actually lost 3 percent per annum since inception—a period during which the S&P 500 rose almost 13 percent a year. Perhaps even more damningly, the fund’s maximum drawdown was over 15 percent, or over 6 times worse than what the strategy had allegedly achieved through much worse market conditions (2008 financial crisis, 2011 European default scare, for example).
Catalyst Systematic Alpha Fund
A more recent example of the danger of indexes is the Catalyst Systematic Alpha Fund (ATRAX), which tracks a newly created index—the BNP Catalyst Systematic Alpha Index (BNPICASA).
Although ATRAX claims a launch date of November 2017, the fund is actually a rebranded version of a then-existing fund, Catalyst Alternative Intelligence Fund. Prior to its rebranding as ATRAX, the fund materially underperformed with an annualized return of -0.9 percent. Over the same period, the newly created index alleged it would return over 60 percent on a cumulative basis, as shown in the chart below. Imagine a fund manager telling you that if only it had managed a different strategy, it would have knocked the cover off the ball.
As part of its rebranding, ATRAX essentially ignored the performance of the old fund and, by changing the criteria of the fund to one resulting in positive pro-forma returns, was able to market itself as if it had historically impressive returns. The chart below shows the full period of newly created index returns back to 2002.
Since it was not constrained by any relevant SEC regulations, the index’s historical performance now magically showed returns of 21 percent per annum without a single down year—on a pro-forma basis, of course, and in the face of its actual returns with its previous strategy.
Not surprisingly, the actual results since the rebranded fund went live as ATRAX just a few months ago have been more of a mixed bag. While a few months is a very short period to analyze, it’s striking that the fund has lost over 7 percent year-to-date though mid-April, with a maximum drawdown greater than in any of the hypothetical 15 years prior to launch, and a standard deviation of more than double what an investor could expect from the “historical” index performance.
As complex indexes proliferate, the risk of investors being misled by funds implying performance through backfilled information will continue to grow. In order to align investor expectations with likely performance, these indexes should be subject to more stringent disclosure requirements. The stakes are even higher when these indexes are attached to retail products. Before more investors are misled, perhaps the SEC needs to step in and provide additional guidance and regulation on how these funds can market their performance, real and hypothetical. At the very least, the government might create a “reasonableness” standard—does the index fund reasonably believe that the projected results could have been achieved—which would have to be met in order to legally market such products based on backfilled returns.
Andrew Beer is Managing Partner and Co-Portfolio Manager, Dynamic Beta at Beachhead Capital Management, a hedge fund replication strategist with more than $500 million assets under management.