What are mutual fund “shenanigans”? Factors that can distort your ability to properly review and assess a mutual fund’s investment performance. Including: intentional or accidental actions by fund managers; survivorship or creation bias; portfolio style drift; window dressing.
All that and more in Episode 33 on the Wilson Wealth Management YouTube channel.
“How can the fund managers affect my ability to assess fund performance?”
In a few ways. Some may be intentional by fund management. Or simply accidental.
If you are analyzing results from the last 5 or 10 years, who generated those returns? Current management? Or was the current team only brought on in the last 3 years? That can be bad if a superior group of asset managers left. But it may be good if a new unit was hired to replace underperformers. In either instance, difficult to attribute longer term performance to a team that did not create the results.
Perhaps the 5 to 10 year performance was all during one type of market. A bull market, where everyone does well. How will the management team perform in volatile conditions or a bear market? Usually useful to assess how managers perform in different market conditions.
Maybe the fund’s managers are “index huggers”. Where the portfolio holdings highly reflect the underlying benchmark index. Yet, as an investor, you pay a management fee for active management. In a relatively small equity market, such as Canada, many large mutual funds may become index huggers by default. Not the manager’s fault. More a reflection of having very limited investment options for very large assets under management. But why pay for that management if you are not getting it?
For additional detail, please read “Mutual Funds: Management”.
“What is survivorship bias? How can it impact my performance analysis?”
Underperforming mutual funds may close down. A few reasons why this might occur. The main one being that if you have 10 investment options and one is consistently in the bottom 10%, would you invest in it? If you already owned the fund and saw that it was in the bottom 10% over time, would you stick with it?
The answer to both is (hopefully) no. The fund will not attract new investment capital. Assets already in the fund will diminish as investors sell and move their proceeds elsewhere. With less assets, fund expenses are spread over fewer investors, resulting in higher management expense ratios. Which further dissuades new investors from coming in. At some point, the fund is no longer feasible and is shut.
The problem is that once a fund is closed, it may no longer be included in peer performance calculations. That distorts average returns for the investment category. As well as fund ranking within that category.
There are 10 funds in a category. Your fund is ranked fifth, right in the middle. Not great, but perhaps tolerable. Suddenly, the three lowest ranked funds close. Your fund now sits in the bottom third. Same fund. Same absolute performance. Yet it goes from right in the middle of the pack to nearer the bottom.
To a lesser extent, similar issues may arise with creation bias.
For a more detail on survivorship and creation biases, please read “Mutual Funds: Survivorship Bias”.
“What is style drift? How can it create fund shenanigans?”
Mutual funds are usually aggregated by investment category and/or style. US small-cap equities. Canadian investment grade corporate bonds. Australian mining sector.
Within a specific style, there tends to be an equal risk-return profile and similar investment universe. Asset managers operate under a somewhat level playing field when choosing portfolio holdings.
Style drift occurs when an asset manager deviates from the stated style. Perhaps taking on added risk, hoping to earn higher returns. The wider the drift, the less comparable performance is between funds in the same category.
A problem for investors in assessing and in the risk they may unknowingly have in their own portfolios.
For more detail, please read “Mutual Funds: Style Drift”.
“What is window dressing all about? Sounds like the store front in my local mall.”
Window dressing is pretty much that. Just before a reporting deadline, fund managers try to make their portfolios more attractive. In the hope that an investor “walking” by, might stop, be impressed, and come in for a purchase.
Window dressing may hide bad investment decisions. Yes, the performance is reflected in the annual results. But when a potential investor reviews year end portfolio holdings, he/she sees Apple, Amazon, Tesla. Not Blockbuster, Kodak, or Enron. That may influence their view of the manager’s skill.
Window dressing can also hide index hugging and style drift.
For more on this potential issue, please refer to “Mutual Funds: Window Dressing”.
A fair bit of information covered. However, if you intend to review mutual fund performance, it is useful to understand how the results may be distorted. Always be on guard for potential “shenanigans”.
