Fund Closures Make Survivors Look Good
It’s the time of year when mutual funds release their quarterly performance figures -- and many investors curse their funds for not measuring up to similar offerings.
But before they criticize their managers, investors should know about “survivor bias.”
Survivor bias makes the performance of mutual fund categories -- large-company stocks, technology stocks, balanced funds etc. -- appear better than it really is, according to a recent study.
That can put funds at a disadvantage when they are compared with their categories, said Brent Brodeski, co-author of the study and managing director of Savant Capital Management, a Rockford, Ill.-based financial planning firm.
Survivor bias occurs because funds that consistently produce poor results are shut down or merged into better-performing funds. When the underperformers disappear, so do their lousy results. Only the returns of the remaining funds -- the “survivors” -- are used when calculating the performance of the various categories, which usually inflates the returns.
“Survivor bias is a sort of grade inflation,” Brodeski said. “The weakest performers are eliminated before they can drag down the performance of the category.”
And that, Brodeski contends, gives investors the mistaken impression that fund managers, as a group, have done better overall than they really have.
The findings weren’t news to industry insiders.
Both Morningstar Inc. and Lipper Inc. -- which dominate the business of compiling mutual fund statistics -- have acknowledged that survivor bias skews their data. But neither firm thinks the difference is significant enough to be cause for concern.
Indeed, the phenomenon holds managers to higher standards, experts note, by comparing their performance only to the “surviving” -- and, presumably, best-performing -- funds in their peer group. That should give investors whose fund managers have merely kept pace with their category some reason to cheer.
Brodeski, however, thinks survivor bias can give investors the mistaken impression that so-called actively managed funds perform as well -- or sometimes better -- than passively managed funds. That misperception could really cost them.
Mutual fund companies tend to charge a lot more to invest in actively managed funds than passively managed index funds, which typically mimic a market or industry index such as the Standard & Poor’s 500.
Active managers need staffs to research stocks and trading desks to buy and sell shares. Passive managers just buy the stocks or bonds that make up the funds’ benchmark indexes.
Actively managed funds usually charge investors 1% or 2% -- or even more -- of their assets each year, while management fees at most index funds are below 0.5%. And because the manager is not actively trading stocks, index funds typically generate fewer taxable gains than actively managed funds.
Over time, those fees and taxes can put a serious dent in returns.
Brodeski found that when higher costs are taken into account, passively managed index funds beat actively managed funds in nearly every investment category over almost any time period.
The fund industry acknowledges that active managers as a whole rarely beat the indexes. But some do. And investors who are lucky enough to be in those high-performing funds can sometimes reap windfalls. Ideally, these managers will lose less in market downturns, too.
But as the markets slowed after the 1990s boom, fees have drawn more notice as they’ve eaten up a bigger share of investors’ returns.
“On an annual basis, the difference doesn’t look that significant. But on a cumulative basis, it’s pretty dramatic,” Brodeski said.
To gauge the effects of survivor bias, Brodeski studied the returns of actively managed funds in 42 categories between 1995 and 2004. He compared them to index returns in the same categories over that period, which included an up market and a down one. Survivor bias skewed the results in 41 of the 42 groupings, he said.
Once the bias was taken out of the data, index funds beat the returns of actively managed portfolios in 37 of the 42 categories, he found, often by a wide margin.
The belief that index funds will outperform actively managed funds is well-established on Wall Street. Studies dating to the 1960s have found that fund managers rarely beat the S&P; 500, especially over long stretches of time.
But because of survivor bias, the difference isn’t always obvious, Brodeski said. For instance, the performance of actively managed funds that invest in foreign stocks would appear to beat foreign-stock index funds over the last decade. But after accounting for survivor bias, the index funds actually outperformed their actively managed peers, he said.
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Kathy M. Kristof is author of “Investing 101” and “Taming the Tuition Tiger.” Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com.
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Inflating results
So-called survivor bias can inflate mutual fund returns by factoring out the results of poorly performing funds that were shut down or merged. Here are examples and their 10-year cumulative return:
Big-company stock: Surviving funds only -- 178.4%, All funds -- 134.5%
Treasury bond: Surviving funds only -- 146.1%, All funds -- 131.6%
Foreign stock: Surviving funds only -- 113.2%, All funds -- 77.6%
Municipal bond: Surviving funds only -- 79.8%, All funds -- 75.9%
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Source: Savant Capital Management
