Why most back-tested performance histories are bunk, and how you can identify the ones that probably aren't.
A version of the following article first appeared in the September 2013 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.
As they are often used, back-tests are merely a legal way of fabricating a statistically bogus history of outperformance and implicitly taking credit for it. I don't think I'm being too cynical. Most back-tested strategies I've seen are problematic. The worst claims are from newsletters and trading-software providers, who can say almost anything without legal repercussions under the aegis of the First Amendment. I've seen claims of "low-risk" 30%-plus monthly returns (or 2,230% annualized), though most typically keep their back-tests in the range of 20%–50% annualized in a sad attempt to maintain a semblance of believability. It appears index providers and exchange-traded fund sponsors have also produced some unbelievable back-tests.