Digging Into the "History" of the New Fool 100 Index and ETF

In this Rule Breaker Investing podcast, David Gardner brought in some special guests to help him respond to his listeners' questions. And given that a few of them relate to the Fool 100 Index -- the relatively new Foolish-recommendation-based stock set upon which we've build our Fool 100 ETF -- it's natural that one of those guests is Tim Hanson, the index's creator.

He and David talk about how the index and the ETF was built and address some issues of potentially confusing metrics, such as: How can the Fool say the index has a "performance" that goes back years before it was designed? And given that the ETF is so new, what's the Fool doing when it gives performance measures that reflect years of growth? As Tim explains, we're not being disingenuous or deceptive -- that would be totally un-Foolish. They also talk about the possibility of future Fool ETFs. (Perhaps one based on the Rule Breakers portfolio?)

A full transcript follows the video.

This video was recorded on Feb. 28, 2018.

David Gardner: Tim, briefly share that story of how you've built the index that has enabled us to have a Fool 100 Fund. What's going on with the Fool 100 Index?

Tim Hanson: So, the Fool 100 Index we built to be something that tracks the universe of Motley Fool recommendations. These are universally stocks The Motley Fool likes. How did we build that universe? We tried to be very plain vanilla about it. It's our first index, so keep it simple so people could understand it.

So, the Fool 100. We take a universe of open recommendations that The Motley Fool has on companies: recommendations from Stock Advisor, Rule Breakers. The services people know and love. We add to that the top 150 stocks from our Fool IQ database just to give us a robust universe of stocks to pick from. We rank them by market cap, which is a very industry-standard way of building an index. And then we just take the 100 largest, market cap weight them, and you've got something that you can backtest the performance of and obviously will track the performance of the Fool universe over time.

Gardner: Tim, when did the index itself -- we're not talking about the fund here. When did the index itself formerly launch?

Hanson: The index itself began being officially published on Nov. 9, 2017, and we were able to backtest the performance of the index using that methodology I described to Dec. 29, 2006.

Gardner: OK, great. So, I've got a couple of questions for you. This one comes in from Nick Greco. Nick took the time to follow up, and I think he even spoke with you directly, so thank you very much for fielding a member question. I'm just going to air it right out here on the podcast, because I think it's a fair and good question. So thank you, Nick, for writing in.

"David, I'm a frequent visitor to Fool.com. A member of Stock Advisor and Rule Breakers with eyes on adding new services. I purchased the new Motley Fool ETF, the Fool 100" -- TMFC is the ticker -- "on day one; but noticed it posted amazing performance results on the Fool.com home page, even though it's brand new.

"After a brief Twitter exchange with Tim Hanson" -- who we have today -- "I was referred to the disclaimer that explained the performance on the Fool.com home page is 'not actual performance.' After some frustration with this" -- in his characterization "out-of-character move for the Fool" -- that's the way Nick puts it -- "I saw the 'since inception' posted performance of 227.85%. That's on the disclaimer page table. Now, if you read the disclaimer, it absolves the 'pre-inception' figures, but implies that the 'since inception' are real." Well, I hope that's not the case, but, Tim, you'll explain this in a sec.

He closes, "Tim explained to me that the results are based on the index." I won't read that, because you can speak to it here. He does close by saying, "For the record, I love the Fool. I am long TMFC and 40-plus other Stock Advisor and Rule Breakers recommendations. If this creative performance trick is a standard industry practice, please forgive my ignorance. I personally think the 'since inception' result should be true or relabeled. Regards, Nick Greco."

Hanson: It's a fair question, and a good question. And it's actually something my team and I have been learning a lot about -- the differences between indexes and index-linked products of which an ETF is a wrapper for an index-linked product. Index and ETFs are different. ETFs can be based on indexes, but they don't necessarily have to be. They're actively managed ETFs, ETFs that track other things.

An index, on the other hand, is a publishing product. It's simply a list of stocks, and anyone can license that list of stocks for use in an index-linked product like a mutual fund or an ETF. And so, what we were able to do with regard to the index is, as I said, we started publishing it formally in November of 2017, so that is public performance of the index in real time.

Gardner: Right.

Hanson: But we were also able to backtest that performance using a consistent methodology with a third-party independent calculation agent. And so, what you're looking at on Fool.com isn't the performance of an ETF or index-linked product. It's the performance of the index, and what we're disclaiming, there, is that the performance we're showing is backtested performance.

If you were to go look up the performance of an ETF -- any ETF -- it would certainly report the performance from the day the ETF began trading; whereas, if you look up an index performance, it is kind of an industry-standard practice to backtest and to see how they would have performed in other markets, period, as long as you disclaim that and tell people that this is backtested performance. It's a thing.

Gardner: Right. So what we're trying to do is we're trying to show you, had this been around for five or 10 years, here's what it would have done, and now that's it's a real thing, as of last November, what it's doing counts every single day. I know you're following it, and any fund -- there is one link to it, and TMFC is the ticker symbol -- that corresponds to that index, we'll give that performance as well.

So, it's a question of what is real and what is imagined, and in this case imagined is something that is kind of a standard practice and something that people would want to know, probably, but we obviously don't want to make people think that this was up for real, because it didn't exist back then.

Hanson: No. There were no index-linked products at the Fool 100 before our sister company launched one, but if another company -- in Japan, let's say, hypothetically -- were to launch a Fool 100 ETF, they would track their performance from the day they launched, and it would be independently tracked from the Motley Fool 100, our sister company one...

Gardner: Right.

Hanson: ... and it would be independent from the index performance, which began being published in November of 2017 and was backtested to 2006.

Gardner: Awesome. So, thank you, Tim, for clarifying that. Thank you, Nick, for writing in. I think it's a very fair question. We're certainly not trying to mislead anybody. I mean, at the heart of The Motley Fool is our belief in transparency and scoring, and so the aim, there, is to show you how that index has done had it been something over the last three, five, or 10 years. But going forward, of course, it's all in the game as of Nov. 9, the thing that you built, Tim, so thank you.

One other, before I let you go. This one comes from @Pfoolhart, Ken Hart, who writes in, "Is a Rule Breaker Investing ETF in the cards at all? Seems like a basket of the top, say, 20 or 50 or even 100 RBI picks might be a real winner and take the edge off the inherent risk of these riskier stocks."

Now, I know you're not working for the Motley Fool sister funds company, but is that something that you're thinking about tracking or have done? What's your take on that, Tim?

Hanson: That's a great question. From the index side... it's funny. At the recent Motley Fool ONE event in San Francisco, somebody came up and asked is there, in the works, a Motley Fool biotechnology index, because I love your biotechnology picks, but if I only buy a few, some of them are big winners. Some of them are big losers. I'd love to get them all in an easy format.

And the answer to that is we are working on creating lots of additional indices. We think there's lots of fun things you can do with The Motley Fool universe of stock ideas with regards to slicing and dicing it for people who might want our technology exposure or our consumer exposure about technology I mentioned. It's just a matter of doing the R&D work to make sure that what we're putting out there, into the world -- and backtesting is a part of that -- is something that we would be proud to put out in the world.

You don't backtest to manipulate it to make it look good in history, but you want to make sure that the methodology that you're putting forward in the future is one that would have stood the test of time and one that you can be proud of putting out as an index and then also something that is possible to be used as an index-linked product would have to meet certain liquidity thresholds and things of that nature to make it tangible, like that. But it's a great idea and one we're certainly excited to look into.

Gardner: Well, I know you and the team are having a lot of fun tinkering with things. As you depart, but before you quite walk out of the studio, Tim, could you just tell briefly the story of EPIQ-AI?

Hanson: Sure. We have a lot of fun tinkering with data and looking at different trends in the universe and implementations of it, and your brother, Tom, came to us after watching the movie AlphaGo, which is about the artificial intelligence program that Google built to play the game of Go and eventually beat the nine times world champion Go player. And at the culmination of that movie he says, "Even though I can't beat the AI program anymore, playing against it is maybe so much better that I'm now better than any human Go player in history."

Tom came to us and said, after seeing the movie, "Hey, could you build a robot that I could compete against to help make me a better investor?" So we put together a little learning program called EPIQ-AI. It's very rudimentary, but it's fun and it's something for Tom to compete against in the Everlasting Portfolio. It's basically a program that picks our favorite highest-conviction stock ideas from the Fool IQ database that I mentioned. Then it allocated a portfolio based on what we call "fundamental size," which is a metric that adds together revenue with a couple of other things to give you the economic footprint of a business. So it's a little bit different from market cap, but a little bit more stable. And then in ongoing rounds, where Tom buys things for the EP, EPIQ-AI will also buy something, or five things, and it will pick the favorite ideas from the database that also have good relative strength, which is a momentum metric that we found adds value to the database over time.

A little update. It's been running for 14 days and it's beating your brother by about 200 basis points already.

Gardner: All right. That's very exciting and a lot of fun. Tim, thanks!

Hanson: Thank you, David!