Larry Swedroe

Survivorship Bias

"Warning: Returns Shown Contain Biases We Are Not Required to Report"

The above headline should be an SEC-required disclosure for advertisements of many mutual funds. The reported returns of many fund families and their funds are often either misrepresentations (intentional or unintentional) of the returns earned by investors, or are at the very least misleading representations. This is because of biases in the data. Let’s look at one of the biases for which disclosures should be required - survivorship bias.

Funds that have poor performance are made to disappear, most often by the fund sponsor merging a poorly performing fund into a better performing one. Unfortunately for investors, only the performance reporting disappears, not the poor returns.

In the most comprehensive study ever done on mutual funds, covering the period 1962-1993, Mark Carhart found that by 1993 fully one-third of all funds in his sample had disappeared. (1) In 1996, 242 (5%) of the 4,555 stock funds tracked by Lipper Analytical Services were merged or liquidated. Let’s see why survivorship bias is so important. In 1986 the then existing 586 stock funds returned 13.4%. By 1996, the 1986 performance had magically improved to 14.7%. How did this 1.4% improvement happen? Twenty four percent of the funds disappeared. (2) As another example, for the 10-year period ending in 1992, capital appreciation funds reported an average appreciation of 18.08%, versus a return of only 17.52% for the S&P 500 index. Once the survivorship bias is eliminated, the returns of all capital appreciation funds that existed during the same 10-year period drops to 16.32%. Actual returns to investors were not only almost 2% per annum worse then they initially appeared to be, but they were also about 1% below the return available to investors in S&P 500 index funds. (3)

Two other studies confirm this view. Lipper Analytical Services found that the return of all general equity funds for the 10-year period they studied was 15.7%. This was 1.5% below that of the funds that existed at the end of the period (the survivors) and almost 2% below the return of the S&P 500. (4) The second study found that over the 15-year period ending December 1992, the annual return of all equity mutual funds was 15.6% per annum. When you include all the funds that failed to survive the entire period, the annual return dropped to 14.8%. The cumulative difference in returns was 781% versus 689%. (5)

The survivorship bias problem has increased in recent years as mutual fund families try to bury poor performance. In 1998 alone, 387 stock and bond funds were merged out of existence, an increase of 43% over the previous year. A further 250 funds were liquidated due to investor redemptions. In the first quarter of 1999, the number of vanishing stock funds jumped 74%. (6) The trend managed to accelerate even further in 2000 as 451 funds were shut down (223) or merged out of existence (222). (7)

The following is a good illustration of the potential impact on reported returns when funds are merged out of existence. Liberty Financial Cos. had been experiencing a serious drain on their assets under management. In 1999 net outflows were over $600 million. In the first three quarters of 2000, outflows increased to over $850 million. In an effort to stem investor defections from its funds, on October 5, 2000 Liberty announced that it was planning to merge out of existence 17 of its 95 stock and bond funds. The 17 funds represented $1.7 billion of investor assets. The assets of the 17 funds were to be merged into 10 existing funds in the Liberty family. (8) I think it safe to assume that the funds that were merged out of existence were the ones with the worst track records. By merging the funds out of existence, Liberty magically made the performance statistics of those funds disappear. The reported returns of the now merged funds will only contain the live returns of the surviving fund. Of course, the poor returns investors received from the defunct fund did not disappear, they just go unreported as if they never were experienced (it's not due to respect for the dead). Future investors in the Liberty funds are clearly not getting the whole story on the returns earned by investors in the Liberty family of funds.

As you can see, while still playing within SEC rules there exists the potential for significant distortion of both the actual returns received by investors and also the potential for repeat performances. Better disclosures might help, but since many investors don’t read the fine print, the public would be better served if these practices were prohibited.

(1) Journal of Finance, March 1997
(2) Wall Street Journal, April 4, 1997
(3) Dow Jones Asset Management, January/February 1998
(4) Burton G. Malkiel, A Random Walk down Wall Street[/:Author:] (5) John Bogle, Bogle on Mutual Funds[/:Author:] (6) Wall Street Journal, May 10, 1999
(7) St. Louis Post-Dispatch, February 7, 2000
(8) Ibid.

Larry Swedroe is the author of The Only Guide To A Winning Investment Strategy You Will Ever Need and What Wall Street Doesn't Want You to Know. He is also the Director of Research and Principal for Buckingham Asset Management, Inc. in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management.