Survivorship bias is an important issue that needs to be addressed when analyzing past performance. It has been the subject of a much important research in recent years and it continues to be debated extensively. Survivorship bias results from the tendency for poor performers to drop out while strong performers continue to exist. Thus when analyzing past performance of mutual funds for example, the sample of current funds will include those that have been successful in the past, while many funds that previously existed but underperformed and were closed or merged are not included. Survivorship bias results in an overestimation of past returns and leads investors to be overly optimistic in predictions of future returns.
Researchers have demonstrated in recent years that survivorship bias can play a significant role in biasing past returns of individual securities, mutual funds, and even equities of specific countries. For example, Professors
William Goetzmann and Philippe Jorion point out that the high historical returns from American stocks may represent an exception rather than the rule when evaluating equity premiums in a worldwide context. See Must Read article History, as written by the winners in Forbes (6/16/97).
LBO Fund sponsors also have a tendency to leave out all the details when reporting their performance. See "The facts, but not all the facts" which was included in a 3/9/98 article in Forbes titled
LBO Madness. A telling quote from the article is "There is no legal requirement that the dealmaker must present a full picture of his or her career."
A technique that some companies use in launching new products is to "incubate" funds. For example, a company wishing to launch a new series of mutual funds might provide ten managers with a small amount of seed money to start aggressive funds. Each manager is given two years to test their stock picking ability. At the end of the period several of the funds are likely to have outperformed. Those successful funds are then made available to the public and marketed aggressively while the losers are silently discontinued. This is what is known as "creation bias."
Once you have an appreciation for the effects of survivorship and creation bias its easy to see how companies can effectively guarantee long term records of outperformance. By starting with a large number of funds and discontinuing or merging the poor performers, a company is left with a stable of cherry-picked winners. Even if a surviving fund only matches the returns of the market going forward, its long term record will continue to be better than the market as a result of the initial outperformance.
Another issue that investors should keep in mind is the tendency for strong performing funds to grow rapidly which has many implications. Many funds that outperform and experience large inflows, subsequently are unable to repeat the performance with substantially higher assets under management. Its also common for funds that outperform over short periods of time to turn around in the following period and underperform. The underperformance frequently occurs with more assets under management. The result is a fund with an average track record, but overall investors in the fund underperformed. See The Vanguard Group's Nothing Fails Like Success by John Bogle.
The following is a simplistic and fictional example, but similar scenarios occur regularly in the investment business. A little-known stock fund with $10 million in assets experiences a period of significant outperformance rising 50% over the course of a year. As a result, the fund (now $15 million in assets) receives a significant amount of publicity and investors flock to the fund. The fund quickly grows to $150 million. The fund then proceeds to lose 10% over the following year.
What is the funds return over the two years? A positive 35% (a little over 16% annually). Yet investors in aggregate have lost more money in the fund than they've made. Gains in the first year were $5 million while losses in the second year where $15 million. The fund has a 2 year track record of 16% annualized returns but investors in the fund are down $10 million. The example demonstrates the difference between time-weighted and dollar-weighted returns. For a real life example see Laszlo Birinyi's The relative performance trap in Forbes (10/13/97).
These issues demonstrate the importance of being skeptical of performance claims, particularly when the claims are coming from the company itself. Also keep in mind that there are numerous ranking systems which increases the likelihood that each fund will be highly ranked by someone over some period of time. Recent decisions by the NASD and SEC regarding track records also complicate some of these issues. In many cases track records will be movable which could create more confusion.
Firms that comply with the
Performance Presentation Standards from the Association for Investment Management and Research are generally not subject to the cherry-picking problem. AIMR requires all accounts under management to be included in at least one composite that is included in their performance reports. Therefore firms that comply can't hide poor performance from their record.
See also
Please send suggestions and comments to Investor Home