Funds’ survivorship bias worse than you think

Survivorship bias is a problem with the way mutual-fund returns are reported. Funds that are liquidated or merged into other funds are eliminated from the averages. Only the surviving funds are included when the aggregate returns are reported by the mutual-fund reporting services or the newspapers. Understanding survivorship bias is important because it overstates the returns of the surviving funds by 1 percent or more per year as stated by Mark Carhart and others in their paper titled “Mutual Fund Survivorship.”

Let’s look at a specific example. Say 10 funds are started by a fund company. After three years, the average annual returns of the 10 funds are shown in Chart A.

Let’s say the market return during this time was 7 percent annually. Funds A through C underperformed the market return of 7 percent by a wide margin. Funds D through F performed slightly worse than the market return of 7 percent. Funds G through J performed the same or better than the market. The average return of the 10 funds is 5.5 percent, while the market returned 7 percent. Now let’s say the fund company that created all these funds was unhappy with the performance of funds A through C. They decide to merge funds A through C into funds H through 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 through C are merged (eliminated), the records of the surviving funds are as shown in Chart B.

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Miraculously, the average return of the surviving funds is 7 percent, exactly the same as the market. The survivorship bias has raised the average return of the surviving funds by 1.5 percent. Therefore, this makes the record of the surviving funds look much better than they actually are. While this practice seems like it should not be allowed, these types of things happen routinely with mutual funds.

According to the Mutual Fund Landscape paper published by Dimensional, only 56 percent of the equity funds that started 10 years ago (ending December 2014) were still around after 10 years. Only 18 percent of the surviving funds outperformed their respective benchmarks. In other words, about 4.6 percent of funds disappear each year.

Hedge fund data even worse

According to the article “Buzzkill Profs: Hedge Funds Do Half as Well as You Think,” the hedge fund industry is plagued by even worse reporting guidelines. Hedge funds or alternative funds as they are sometimes called, voluntarily report their returns to the hedge-funds’ databases. In addition to survivorship biases, hedge funds are subject to backfill bias, a.k.a. instant history bias, and extinction bias because hedge funds tend to only report returns when they are good. Simply put, hedge funds that aren’t performing well don’t report their returns to the database. The article explains that when adjusting for all of these biases, for the period from 1996 to 2014, the mean annualized return of hedge funds dropped from 12.6 percent to 6.3 percent.

Let’s look at the example shown in Chart C.

Supposing a hedge fund had the above returns, it could decide to only report the returns from years 5 through 9 to the hedge-fund database. If you only look at those years, the returns average 12.6 percent. Yet, if you include all the years, the average annual return was 3.5 percent. It’s easy to see in this example how the returns in the database can be manipulated through voluntary reporting bias.

Another example can be seen in Chart D.

In this scenario, midway through year 6, the hedge fund could decide to report all its previous history in Years 1 through 5. This returns look great at this point, with an average annual return of 12.3 percent annually. Then when things go south, in years 7 through 9, they decide not to report at all. The returns look reasonable in years 1 through 6 with a 10.3 percent average. Yet, if you look at the full record, the returns averaged -5.4 percent annually. When hedge funds start falling apart they stop reporting well before they blow up. This simple example makes it easy to see how the returns can be manipulated through extinction bias.

Why is all this important? Most individual investors are not aware of the problems with the way mutual- and hedge-fund returns are allowed to be reported. It may be savvy for most investors to avoid hedge funds or alternative funds because they are saddled with high fees, poor performance and relaxed reporting guidelines.

Robert J. Pyle is president of Diversified Asset Management Inc. Contact Pyle at 303-440-2906 or info@diversifiedassetmanagement.com.