When it comes to investing many investors care about one thing and one thing only – the bottom line. How much profit/loss did I experience this quarter/year. Ironically, published mutual fund returns are not always as they appear. This is partly due to what we in the industry call the “survivorship bias”.
In short, the survivorship bias distorts how funds stack up against each other. It happens when mutual fund companies need to drop or merge funds with poor performance. It leads to an overestimation of their surviving mutual funds past returns. Confused? Here’s an example…
Imagine funds A, B, and C in a given category. Fund A has an annual total return of 5%, fund B records 10%, and fund C 15%. The average total return of these three funds would be 10%. But, if the poorest performer (fund A) were to be liquidated or merged with fund B or C, it would essentially disappear. The average return of the surviving mutual funds would then jump from the original 10% to 12.5%.
A study was done by Professor Mark Carhart which showed that 1/3 of all stock funds disappeared from the years of 1962 to 1993. Even in a shorter period, the same trend remains. From 1988 to 1992, 100 of the original 686 funds disappeared. Thats nearly 15%! And more recently from 1993 to 1998, an astonishing 600 equity funds disappeared!
One could ask how this is legal. Mutual fund companies are basically manipulating numbers for their benefit as they choose. Fund companies claim they shouldn’t have to include “dead funds” in their return calculations because they’ve been transferred to different managers. I beg to differ in opinion.
The CFA institute has tried to monitor how past performances are recorded but disclosure of these instances isn’t a requirement for mutual fund companies. There are loopholes that can be jumped through to the point where even if the company does comply, all they have to do is report it in the fine print of the prospectus to hide it.
I’ve run studies multiple times on basic index fund performance (such as DFA / Dimensional Fund Advisor mutual funds) versus the average actively managed mutual fund manager. Index funds, or DFA Funds in many of my studies, outperform anywhere from 70% to 90% of their actively managed mutual fund counterparts. These studies use various timeframes and compare each index option and DFA fund to the entire universe of it’s true benchmark peers. If you’d like copies of my research, simply contact me through the website.
70% to 90% outperformance – seems crazy one would try to pick and choose active fund managers when even my 7 year old twin boys know that picking the 70% sure thing is smarter than gambling on getting an additional 10% to 30% in outperformance.
Unfortunately, due to survivorship bias, these numbers aren’t accurate. The fact is, I’m comparing index funds and DFA mutual funds to the currently active managed fund investment options. When in fact, what I should be doing (if the data were actually available) is measuring index funds and DFA mutual funds agains ALL mutual fund peers (both in existence and closed or merged) for any given time period.
Measuring index funds and other DFA mutual fund investments against a complete group of ALL peers both closed AND open would mean DFA funds and index fund alternatives would outperform EVEN MORE than the current estimates of 70% to 90%! This would make doing anything BUT DFA funds and indexing seem downright foolish (as if it’s not already foolish enough)!
It’s easy to see why this is such an important issue to take into account when analyzing the past performances of funds. You have to take all past performance claims with a grain of salt, especially when the claims are coming directly from that company. The only way you can truly be sure about what they are getting yourself into is by taking the time to do your own research.
