In March, MSCI came out with the Diversified Multi-Factor Index family, or DMFI. It is MSCI’s most ambitious index family to date. With it, MSCI has made the leap from purveyor of simple index strategies to become a sophisticated quantitative equity manager. If the back-test is to be believed, the ACWI DMFI would have beaten the ACWI, a global market-weighted index, 15 out of the past 16 years, the sole exception being 2008.

Here is a chart plotting the cumulative wealth ratio between the ACWI DMFI and the ACWI. When the line slopes up, the DMFI is beating its benchmark. The slope is unreasonably smooth. The same exercise done with the USA flavor of the DMFI shows a similar pattern.

MSCI must have worked with iShares. Just a month after MSCI announced the index, iShares launched FactorSelect exchange-traded funds tracking various DMFI flavors.

This sets up an interesting experiment. If a back-tested strategy beats its benchmark year after year, there’s nowhere to hide if it flops in a live environment. You can't explain away its failure as statistical noise. Either the strategy was data-mined or the market evolved to render it obsolete.

You may want to dismiss the DMFI as a product of back-testing gone amok. However, MSCI is an imitator. All the firm has done is apply popular academic and practitioner research that purports to have identified stock characteristics associated with excess returns: value, momentum, quality and size. The DMFI is hybrid knockoff of strategies offered by Dimensional Fund Advisors and AQR, two fund managers supported by a roster of academic finance superstars.

I'm a skeptical believer in these factors (except size). I'm a believer because I think there is some excess return to be had from factor strategies; I'm a skeptic because I doubt the return will be as smooth as indicated by the backtests. Time will tell if the DMFI flops. If it does, there’s a good chance DFA’s and AQR’s multi-factor strategies will flop right alongside it.