IN THE SEARCH FOR THE NEW and different indexes that will power a new and different ETF, back-testing plays a critical role. Index providers, including S&P, Dow Jones, MSCI, Russell, Zacks and others can index just about anything. You want to rank the companies in the S&P 500 by earnings growth, then take the 50 top firms and weight them equally? Weight them by market capitalization? Go long the top 50 and short the bottom 50? They can build it. And then they back-test it. Indexes that look good in hindsight have a shot to become ETFs. Those that don’t, don’t.

Given our quantitative roots, we are sympathetic to the fact that backtests are often used as an input into making investment decisions. But past returns, as we all know, do not predict the future. And we think backtested results may be particularly problematic today. Very little fundamental data for US equities extends back more than 30 years, but the last 30 years were a period generally accompanied by two related phenomena: increasingly easy monetary policy and falling interest rates. In particular, the wave of liquidity and stimulus provided in the wake of the Tech Bubble coincided with unprecedented levels of credit expansion, rising asset correlations and record earnings volatility.