Courtesy of Paul Amery

Remember to check the assumptions made for the cost of trading when examining a new index concept.  ( Editor note: read between the lines, even though the phrase “best execution” is missing from this piece, the article should inspire thoughtful consideration re what true best execution entails).

Vanguard’s warning of the perils of index data mining is timely. As the number of “smart beta” index concepts increases, each promising superior performance than old-fashioned, capitalisation-weighted benchmarks, the possibility of investors getting hoodwinked also grows.

Just about anything can be used to “predict” something else if you use historical data series creatively enough. According to fund manager David Leinweber, the Wall Street Journal reports, annual butter production in Bangladesh “explained” 75% of the annual returns of the S&P 500 over a 13-year period. If you throw in data for US cheese production and the combined sheep population of the US and Bangladesh, Leinweber says, you get to “forecast” US stock prices with 99% accuracy.

Not everyone got the joke. A number of firms asked Leinweber to share his data on Bangladeshi butter production so that they could build a trading strategy around them, the WSJ tells us. Were any index and ETF providers looking for a new smart beta concept among them, by any chance?

Vanguard has its own axe to grind in all this, we shouldn’t forget. The firm sticks religiously to using traditional, cap-weighted indices as the basis for its passive funds, arguing that anything else is an active bet on market behaviour and should be recognised as such. I’ve argued before that this is as much as a commercial strategy as anything else—Vanguard’s huge size precludes it from even considering index concepts that are in any way capacity-constrained, as many non-cap-weighted approaches are. Continue reading →