7/27/04 - Survivorship BiasSurvivorship bias is a problem in the way that mutual fund returns are reported. Survivorship bias means that only the surviving funds are included when the aggregate returns are reported for all the funds by the mutual fund reporting services or the newspapers. Funds that are liquidated or merged into other funds are eliminated from the averages. We will give an example of this later. This survivorship bias is important because it overstates the returns of the surviving funds by 1% or more per year. The Wall Street Journal had a good article about this in the July 23rd issue in the Money and Investing section.
Let’s look at a specific example. Say 10 funds are started by one fund company or maybe multiple fund companies (this fact is not really important). After 3 years the average annual returns of the 10 funds are as follows:
|
Fund |
A |
B |
C |
D |
E |
F |
G |
H |
I |
J |
10 funds |
|
Avg Return |
1% |
2% |
3% |
4% |
5% |
6% |
7% |
8% |
9% |
10% |
5.5% |
Let’s say the market return during this time was 7% annually. Funds A-C under performed the market return of 7%, by a wide margin. Funds D-F performed slightly worse than the market return of 7%. Funds G-J performed the same or better than the market. The average return of the 10 funds is 5.5%, when the market returned 7%. Now say one fund company started all these funds and they were unhappy with the performance of funds A-C. They decide to merge the funds A-C into funds H-J respectively. Specifically, fund A is merged into H, fund B is merged into fund I and fund C is merged into J. After funds A-C are merged (eliminated), the records of the surviving funds are as follows:
|
Fund |
D |
E |
F |
G |
H |
I |
J |
7 funds |
|
Avg Return |
4% |
5% |
6% |
7% |
8% |
9% |
10% |
7.0% |
Miraculously, the average return of the surviving funds is 7% and exactly the same as the market. The survivorship bias has raised the average return of the surviving funds by 1.5%. Therefore, this makes the record of the surviving funds look much better than they actually are. It could have worked a different way. Funds A-C could have been started by ABC fund company and funds D-J could have been started by XYZ fund company. Then, XYZ fund company could have purchased ABC fund company and merged funds A-C into funds H-J of fund company XYZ.
Historically, about 3-4% of the mutual funds are liquidated or merged into the other funds each year. Mark Carhart supports this fact in his article “Mutual Fund Survivorship”. This is important because it is often quoted that 15% of the funds outperform the market index over the long term. Well, the 15% number is based on the surviving funds. Let’s look at another example, where there are 1000 funds at the start of a ten-year period. Then each year 3% of the funds are eliminated, so after one year there are 970 funds left. After two years there are 941 funds left. After 10 years there are 737 funds remaining and 15% of those funds beat the market, which equates to 110 funds. If you do the math, that is 110 funds outperforming the market or really 11% of the original 1000 funds. Therefore, the number of funds that outperformed the market in this hypothetical example is overstated by 36.36% (15/11= 1.3636-1=36.36%).
Why is all this important? It is important because most individual investors are not aware of the survivorship bias problem in the way mutual funds returns are reported. As a financial advisor, we typically avoid actively managed funds and choose passively managed and index type funds for our client portfolios. These funds tend to perform better and are more tax efficient.
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