The 18-time Grand Slam winner, 33, was 16 when she lost 6-1 6-1 to Joannette Kruger in Oklahoma City – the last time she failed to win more than two games.
Romanian Halep, 23, said she had played “the best match of my life”.
“Embarrassing describes the way I played today,” said Williams, adding she had served better in junior tennis.
The loss in the round-robin match ended Williams’ 16-match winning streak at the end-of-year tournament, which she has won for the last two years and four times in all.
Halep, the fourth seed, allowed her American opponent to win just six points on serve on the way to breaking three times in the first set.
Williams improved in the second set, carving out six break points, but Halep saved them all on the way to sealing the convincing win.
“My forehand was off today again. I guess it went on an early vacation,” added Williams, who said she had served better “in the 10 and under division in juniors”.
The end-of-season competition features the top eight ranked players in the world. Two sets of four players face each other in round-robin matches, before the top two in each group advance to the semi-finals.
Williams, who withdrew from the China Open this month with a knee problem, credited Halep’s performance and said fitness had nothing to do with her loss.
“I think Simona played really well,” she said.
Halep was ranked 47 in the world two years ago, and had never beaten a top three player before,
She said: “It was my best match of my life. I played unbelievable shots. It means a lot this match.”