Analyzing mutual fund performance may seem straightforward.
Look at a fund’s results for different time periods. Then compare returns against peers and relevant benchmarks. And away you go. Unfortunately, relative performance can be distorted through survivorship bias.
Today we will look at this issue and its close relation, creation bias.
Survivorship Bias
Survivorship bias makes performance figures for a fund family (or investment style) appear better than they really are.
The bias occurs when under-performing funds are liquidated or merged into other funds. Over time, certain funds (and their historically poor performance figures) disappear from the fund family charts. With the weak funds no longer on the books, the average performance for the fund family and the investment category improves.
Think of a class of 10 students with the following averages: 96%, 90%, 88%, 80%, 74%, 70%, 68%, 22%, 12%, 10%. Your average is the 68%.
The simple mean average for the class is 61%. You are quite pleased to be in the top half.
However, the bottom three students drop the class after mid-terms. Their marks are removed from the class average. A new class average is calculated at 81%. You have now moved from the top half to the bottom. Congratulations!
This is the effect of survivorship bias. True performance gets skewed upwards when poor performers are eliminated from the calculations. The mediocre or weaker performers look even worse in the new comparison.
You can see that you need to be cognizant of both effects when analyzing mutual funds.
When assessing a fund family or investment style, poor performers may disappear causing the family or style to have better performance than they really had.
When analyzing funds that rank in the middle or lower half of an investment style, bear in mind that there may have been weaker performers in the group. But they have been discarded making the mediocre funds appear even worse.
Survivorship Bias Frequency
Liquidating weak funds is a common occurrence in the mutual fund industry.
While the impact of survivorship bias may not be rampant, it occurs frequently enough to be a concern for investors.
It can be an intentional act by a fund family to improve performance data or possibly an unintended consequence due to natural changes in individual funds.
Most mutual funds want to attract new investors and increase assets under management. That is how a mutual fund makes its profits.
If performance of a fund is poor over time, it will have difficulty attracting new capital. Further, poor individual fund performance may reflect negatively on the fund family which manages the fund.
It may be in the fund family’s best interest to shut down the under-performing fund or consolidate it into another fund, making its historic results vanish.
Acceptable treatment in many jurisdictions, but not what I consider an overly ethical practice.
Then there are the funds that disappear due to more natural occurrences.
For example, say there is an investment style for which only 4 mutual funds exist. The 1, 5, and 10 year returns for each respectively are: A: 27%, 25%, 22%; B: 32%, 30%, 19%%; C: 18%, 21%, 24%; D: -12%, -8%, -4%.
Assuming all other analytical considerations (e.g., manager tenure, expense ratios, etc.) are similar, would new investors ever consider mutual fund D? Probably not.
And I expect that existing shareholders in fund D would become frustrated with D’s performance and begin to shift their money from D to the other funds.
Over time, unless D improves its relative performance, its asset base will fall significantly. Part of the problem is the negative returns erode fund assets. Second, as shareholder redemptions increase, the fund must convert higher portions of its investments into cash to pay exiting investors. This should restrict fund manager investment tactics and further impair future performance. Finally, as assets leave, expense ratios will rise which further hurts results.
The cycle will continue until results improve and the money outflow ceases. Or, at some point in time, all the assets of the fund will be gone. At that point, the fund will be terminated.
Creation Bias
You may also come across the term creation bias.
Creation bias is a type of survivorship bias.
Fund families often provide seed capital to fund managers to create new funds. These funds are run privately for a short period (e.g. two years).
Any successful funds are made available to the investing public, while the poorly performing funds are liquidated and their results “disappear.”
Assessing Survivorship Bias
This is often difficult to assess in a fund as reporting requirements are not strong in this area.
Some funds do disclose this information, so check the fine print on their websites or ask them about how they report results from discontinued funds.
The best way to avoid these two biases is to focus on funds with superior long-term (i.e. 10 year) performance. That allows you to assess a specific fund’s performance on its own merits and not simply short-term results that may look good in comparison to other funds simply because the poor performing competition has disappeared from the charts.
