Mutual Funds and Hedge Funds – The Survivorship Bias Problem – Returns Are Worse Than You Think!!!

Survivorship bias is a problem with the way that 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% 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 3 years the average annual returns of the 10 funds are as follows:

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%, while the market returned 7%. Now let’s say the fund company that created all these funds was unhappy with the performance of funds A - C. They decide to merge 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:

Miraculously, the average return of the surviving funds is 7%, 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. 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% of the equity funds that started 10 years ago (ending December 2014) were still around after 10 years. Only 18% of the surviving funds outperformed their respective benchmarks. In other words, about 4.6% of funds disappear each year. 

Hedge fund data is 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, aka 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% to 6.3%.

Let’s look at the following example: 

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

Let’s look at another example:

In this example, mid-way through year 6 the hedge fund could decide to report all of their previous history in years 1 - 5. These returns look great at this point with an average annual return of 12.3% annually. Then when things go south, in years 7 - 9, they decide not to report at all. The returns look reasonable in years 1 - 6 with a 10.3% average. Yet, if you look at the full record, the returns averaged -5.4% 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. 

In Jim Parker’s article, Hedge of Darkness, he cites Simon Lack’s book called The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to be True. Lack estimates that the hedge fund industry captured at least 86% of the returns it earned for it customers from 1998 to 2010, leaving only 14% of the profits for the end investor. Apparently, the only ones that get rich from hedge funds are the hedge fund managers. 

Why is all this important? Most individual investors are not aware of the problems with the way mutual and hedge funds 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, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

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