WSJ's Zweig Misfires Touting Latest Back-testing Breakthrough

The Wall Street Journal should know better.

In early March, the Journal’s Intelligent Investor columnist, Jason Zweig, wrote an article about the discovery of a financial measure that appears to consistently “identify companies that will earn even more money in the future.”

Here’s the money quote:

Research to be published soon in the prestigious Journal of Financial Economics by Robert Novy-Marx, a finance professor at the University of Rochester, shows that bargain-priced "quality" stocks outperformed the overall market by more than four percentage points annually between 1963 and 2011.

Specifically, Professor Novy-Marx’s magic formula requires you to merely take the gross profit of a particular company and divide it by that company’s total assets.  If that results in a number greater than 0.33, bingo! You’ve got yourself an outperforming stock.

Of course, by now, your Spidey sense should be tingling - or at least your investing common sense should be saying “hold on a minute.” Isn’t there someone sensible at the Wall Street Journal to point out how flawed this line of thought is? Maybe someone who should know better? Maybe they’d put it this way:

Every year, billions of dollars pour into data-mined investing strategies. No one knows if these techniques will work in the real world. Their results are hypothetical -- based on "back-testing," or a simulation of what would have happened if the manager had actually used these techniques in the past, typically without incurring any fees, trading costs or taxes.

Guess who wrote those words? You got it: Jason Zweig, in his Intelligent Investor column in the August 8, 2009 WSJ.

Now, I’m a little crossed up over this, because in general I have a lot of respect for Mr. Zweig. My firm’s web site even links to the aforementioned “data mining” piece as an example of how we do our best to avoid easy-to-make investing mistakes.

But in Mr. Zweig’s piece about this new “quality” metric, he seems to lack his usual skepticism about easy paths to investment returns. What’s more, he gives free advertising to the fund sponsors who have already rolled out funds to take advantage of this new-found “quality” measure. A money manager at one of these firms is even quoted as saying, “[w]e don’t know exactly why it works, but it works.” That’s not comforting, but in a world where billions are gambled away in casinos, it’s not surprising either.