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Market Sense and Nonsense: How the Markets Really Work (and How They Don't) by Joel Greenblatt, Jack D. Schwager

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Chapter 7

Sense and Nonsense about Pro Forma Statistics

Pro forma is a most unfortunate and confusing term in the sense that it is used in virtually opposite contexts. Pro forma results are based on presumed representative returns as opposed to actual returns and are used when actual returns are unavailable or are considered to be in need of modification. In practice, however, pro forma returns can range from unrepresentative and misleading to more representative than so-called actual returns.

As one example of the misleading uses of pro forma numbers, consider a new fund of funds that employs a track record based on how the portfolio would have performed in the years prior to the fund’s inception based on the actual track records of the funds selected for the portfolio. It’s easy for investors to be fooled into believing that such pro forma results are representative because, after all, they are based on actual track records. The catch, however, is that only funds with good past performances will be selected, and the knowledge of which funds would have experienced superior performance would not have been known prior to the achievement of their outperformance. There is, in fact, no reason to assume that a largely similar portfolio, let alone the same portfolio, would have been chosen at the start of the pro forma period and subsequently maintained throughout the period without changes. Thus such pro forma results will be highly biased because, although the portfolio results are ...

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