The bulk of reported backtest results involving securities that pay dividends are based on adjusted data. The dividend-induced drift has a special effect on momentum models, relative or absolute. In many cases users of such models believe that their risk-adjusted returns are due to timing ability of the models when in fact they are being fooled by an upward drift due to dividend adjustments.
Update [08/10/2015]: A specific example is given in another post. If you would like to post a comment about adjusted vs. unadjusted data use the comment section of that post.
Quantitative trading is primarily about time-series analysis and then about hitting the backtest button to get performance results. However, most trading system developers do not go through the preliminary steps to understand the data series they are dealing with. As a result, the financial blogosphere is bombarded daily with unrealistic results of momentum models, relative or absolute, based on backtests that do not correspond to actual prices of the past, i.e., they are based on unrealistic market conditions.
Enter the Chaos
I have talked about the “chaos” adjusted data has caused in technical analysis in a series of articles. You can find the articles in my archive by searching for the keyword “chaos”. Here is a link to the last one in the series.
This is not even funny: How many traders, professionals or even funds have been fooled by adjusted data? It is hard to say. One thing I know from personal experience is that it took many years for people to find out that the two most popular backtesters used in the 1990s had major flaws, often producing unrealistic results. This may have to do with the “Ostrich effect” cognitive bias: Most people just wish that there are no problems with what they do. But always keep in mind this:
If finance, more than often very good results are probably due to a flawed process
I will provide two examples below using adjusted and unadjusted TLT data, an ETF that is popular and it is being used in all sorts of momentum rotation and trend-following systems for asset allocation. The first system to backtest is a 50-200 moving average crossover, as follows:
Buy if 50-day MA > 200-day MA
Sell if 50-day MA < 200-day MA
Equity is fully invested and commission is set to $0.01/share. The backtest period is from inception of TLT on 07/30/2002 to 12/31/2008, as shown on the chart below, where TLT is the adjusted series and $TLT at the bottom chart the unadjusted one:
Notice the strong uptrend in the adjusted TLT price series. This is only due to dividend adjustments. The actual series, shown on the bottom chart, does not exhibit a strong uptrend.
Accordingly, the results of the backtest of the 50-200 moving average crossover system vary widely. The adjusted data produce a Sharpe ratio of 0.35 where for the unadjusted it is only o.02. Note that in actual trading you buy actual prices, not adjusted. In case dividends are paid during the holding period of a trade, then performance must be adjusted accordingly but that will not be due to some timing ability of the system used to enter the trades and this is the main point made here.
The above chart tells an ugly story, i.e., how traders with a backtesting program can get fooled by dividend-induced upward drift into thinking that they have a superb timing model.
Let us now look at a popular timing model used in absolute momentum allocation schemes that involves a 1-10 crossover on monthly data, as follows:
Buy if close of this month > 10-month MA
Sell if close of this month < 10-month MA
Below is the chart of adjusted and unadjusted series with the results for this backtest:
Here the variation is more pronounced and performance on actual data is negative, as opposed to a large CAR on adjusted data. The positive CAR on the adjusted series only reflects the upward drift from future price adjustments. Actually, past results depend on future dividend adjustments. If you are a system developer and you do not realize how severe this effect is, then you ought to consider it. Do your models really have timing ability or are you being fooled by a dividend-induced drift?
You can subscribe here to notifications of new posts by email.
Charting program: Amibroker
Detailed technical and quantitative analysis of Dow-30 stocks and popular ETFs can be found in our Weekly Premium Report.
© 2015 Michael Harris. All Rights Reserved. We grant a revocable permission to create a hyperlink to this blog subject to certain terms and conditions. Any unauthorized copy, reproduction, distribution, publication, display, modification, or transmission of any part of this blog is strictly prohibited without prior written permission.