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S-Network comments on back testing indexes

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Richard Phillips (pictured), Co-Founder and Head of Index Operations at S-Network Global Indexes, a provider of more than 200 indexes which serve as the basis for over USD8 billion in financial products, believes that index back testing processes require strong evaluation.

“My concerns fall into three areas,” he says. “First there’s transparency. For a back test to stand, it must be based on a mechanistic, formulaic process that is fully disclosed. If there is discretion involved then the back tests are invalid.”

Phillips says that there are efforts to inject degrees of discretion into the methodologies. “A degree of discretion can cover a lot of territory. It may be that when you don’t have sufficient levels of transparency everything is being done by the book, but there could be little lapses where there may be mistakes or errors that you can’t check. It’s unauditable.”

His second concern is about the actual data quality. “This is something that people fully recognise as being problematic,” Phillips says.

“We bring data in from the major providers such as Bloomberg, Reuters or S&P IQ and a lot of the data is duplicative. If you try to draw down data from a single source, you are going to have some variances and the further back in time you go, the greater those variances become. You need a solid universe of stocks to make your methodology effective. We have five independent data sources. Our primary source is Reuters, but we still need to confirm and modify their data. Obviously, if you don’t have clean universes, you are working with a garbage in/garbage out situation.”

The third element that concerns Phillips is investability. “One of the things we stress is when an index goes into the market, it is investable. When you do a back test, you are conducting it in a frictionless, zero cost environment. You need to put overlays on to any successful back test to ensure liquidity.”

Phillips explains that his firm has screens for market cap and trading liquidity so that the indexes don’t pick up excess friction when they go into the market.

Commenting on the term smart beta, Phillips says that he finds the term a bit hackneyed and his firm tried to come up with an alternative, ‘disclosed alpha’.

“What we are seeing in the US are lower fees and that by definition facilitates further flows out of active into passive which is a major trend in the market. You are also seeing engineered products that firms their active management processes. You are going to see major asset management firms that are grounded in active management moving into the ETF market – into smart beta or educated indexes or disclosed alpha who will have a leg up. That leg up will come in the form of large-scale  wholesaling operations and broad educational capabilities.” 

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