Laggards Fall in a Kind of Financial Darwinism : Investing: Result can be overstatement of group returns, especially over longer spans of time.

If Charles Darwin were alive today, he might have something to say about survival of the fittest in the mutual fund industry.

Just as non-competitive animal and plant species have gone extinct, so too have under-performing mutual funds. Funds don’t die off per se, but they do get merged into healthier rivals. When this happens, not only do the laggard funds disappear, but their disappointing track records vanish with them.

This phenomenon is known as “survivorship bias,” and it has some implications for mutual fund investors.

“Survivorship bias means ignoring in the presentation of mutual fund returns those funds that failed to survive over a given period,” John C. Bogle, chairman of the Valley Forge, Pa.-based Vanguard Group, writes in his new investment book, “Bogle on Mutual Funds.” “Since it is almost always the poorer performers that drop out of the race, aggregate returns are overstated,” he says.

Bogle estimates that the reported average gain for general equity funds from 1978 through 1992 was 15.6% compounded annually. But if you included the performance of funds that fell by the wayside over that period, the true return is only 14.8% a year.

Survivorship bias is thus something to keep in mind when comparing fund group returns to the performance of market indexes such as the Standard & Poor’s 500 or alternative types of investments.

In an interview, Bogle said his main concern is that novice investors will overestimate the returns they’re likely to earn on stock and bond funds--a realistic danger considering that many people select funds primarily on the basis of performance.

But while survivorship bias is a phenomenon that’s worth noting, it’s not worth losing sleep over. In the overall scheme of things, it’s not a major problem, for a variety of reasons.

First and most important, investors buy individual funds, not group averages. Yet the effect of survivorship bias is to exaggerate group returns, not single-fund performance.

Second, survivorship bias seems to have a significant effect over relatively lengthy periods, with less impact over shorter spans.

Yet longer-term numbers are suspect anyway, considering that so many portfolio managers have changed or left their jobs within the past five or more years.

“When a manager leaves, a fund’s track record ceases to have any meaning whatsoever,” says James Fletcher of Fletcher Capital Advisors, a money management firm in Newport Beach.

Third, the impact of survivorship bias is spread unevenly. Over the past five years, for example, a performance differential is more evident in certain categories, such as the capital appreciation and world income funds, but less so among other types of funds, such as growth and income.

Even more important than survivorship bias are other red flags. Here’s a look at some of the factors to watch out for when evaluating mutual fund performance numbers.

- Check to see if “loads” or sales charges have been subtracted from the reported total-return numbers. Usually, this isn’t the case.

A sales charge can greatly influence a fund’s performance, especially if the load is large and the time span under study is small, notes Ken Weber, a Lake Success, N.Y., money manager.

Although most reported fund performance numbers exclude the impact of loads, companies are required to report their results after operating expenses such as management fees and so-called 12b-1 marketing charges. You can rest assured that these costs have already been subtracted from the reported total-return figures.

- Check to see if the fund’s character has changed dramatically over the period.

“A key question here is whether most of the performance was earned when the fund was much smaller,” says Greg Ellston, vice president of mutual funds for Rauscher Pierce Refsnes in Dallas.

Some of the best performers enjoyed their biggest gains in years when they were only a fraction of their current size. Preferably, a portfolio will show consistent growth over time.

- Above all, be aware of the distinction between a fund’s yield and its total return.

The former, calculated in various ways, measures the amount of current interest or dividend income spun off to shareholders as a percentage of their total investment.

The latter includes the yield as well as gains or losses in the fund’s share price and thus is a more telling indicator of performance.

*

First-time purchasers of mutual funds tend to be younger and less affluent than experienced investors, a recent survey shows.

A telephone poll conducted for the Investment Company Institute in Washington indicates that people who bought their first fund between July, 1991, and July, 1993, had a median household income of $55,000 and a median age of 40.

The typical “seasoned” fund investor who bought during this period was 45 and earned $64,000.

*

Continuing what has been a modest industry trend of late, two no-load groups say they will lower their annual fees for investors in individual retirement accounts.

Twentieth Century Mutual Funds of Kansas City, Mo., is waiving its $10-per-IRA yearly fee on accounts with values of more than $10,000. Chicago-based SteinRoe Mutual Funds is eliminating its $12 annual fee for IRAs with balances above $5,000.

Biased Results

Performance figures for broad categories of stock mutual funds are skewed by a phenomenon known as “survivorship bias.” That is, when laggard funds get merged into healthier ones, their performance numbers also vanish. The effect is to overstate industry returns by a modest amount, as shown here.

1992 Average Total Return, Stock Funds:

Survivor Funds: +6.52%

All Funds: +6.03%

Source: Lipper Analytical Services