89.3 F
San Fernando
Monday, Jun 17, 2024

Personal Finance—How the Fund Industry Can Benefit from Survival Bias

In mutual fund families, the ugly children die. Funds with poor performance and funds suffering from shareholder redemptions are discreetly led out of public view. Then they are merged into similar funds that are more successful. Others are simply liquidated. Most of us don’t notice these disappearances because there are a lot of mutual funds out there. It isn’t surprising, with a total of more than 10,000 funds, that some funds are never noticed and are eventually lost. But you notice if you’re a shareholder. In August, shareholders in four Aetna funds noticed because Aetna High Yield fund, Index Plus Bond fund, Mid Cap fund and Real Estate Securities fund were liquidated, whether you owned A, B, C or I shares. During the same month, Dreyfus liquidated its Premier Market Neutral and Premier Real Estate funds, Heartland liquidated its Government fund, and Merrill Lynch merged its Utility fund shares into its Global Utility fund. Altogether, 111 funds were either liquidated or merged during the month, according to Morningstar. According to Wiesenberger, a Thomson Financial subsidiary that has been tracking mutual fund performance since the ’50s, we are heading for the first year in which more mutual funds will disappear than will be created. Its count shows that 236 new funds were introduced so far this year but 176 were liquidated and 419 were merged. That means the total mutual fund universe has actually decreased by 359 funds. The firm also notes that the fourth quarter is the most active time for liquidating and merging funds. This figure will probably be higher by year-end since there are nearly 4,000 funds that are at least three years old but have less than $50 million in assets under management. So why am I telling you this? Is this yet another bit of investment trivia? Or does it actually have some implications for you and me? Mutual fund liquidations and mergers are not a trivial matter because they are part of a dirty little statistical secret. All the performance figures that are available suffer from what statisticians call “survivor bias.” This means that the apparent performance of mutual funds is nudged upward by the fact that we are always losing the performance of the funds that are liquidated while retaining the performance of the funds that survive. How big is the survivor bias? It depends on whose research you use, but most puts it at a minimum of 1 percent a year. Accounting and statistics expert Burton Malkiel, for instance, puts the figure at 1.5 percent. If the average fund appears to provide a return of 15 percent, then the average investor has probably experienced a return of 1.5 percent less, or 13.5 percent, after we include what happened to all the money in the underperforming funds. Probably the most important message here is that the benefits of index fund investing are, if anything, understated. Managed fund advocates, for instance, are now crowing about how terribly index funds are trailing managed funds. In the 12 months ending Sept. 30, the average domestic equity fund provided a return of 28.21 percent, trouncing the S & P; 500 index by 14.94 percent. Extend your investment horizon to three years or longer, however, and the average performance of all the surviving funds still trails the index by a substantial amount. Over the last 15 years, the average domestic equity fund returned 15.44 percent, trailing the S & P; 500 index by 2.45 percent a year. The difference, over that period, means that a $10,000 investment grew to $86,168 under management instead of $118,074 in the index. If the average managed fund return were reduced by the estimated 1.5 percent-a-year survivorship bias, the average managed fund would have grown even less to only $70,818. The difference, for you and me, is major. It’s also major for the managed mutual fund industry because they make more money on managed funds than on index funds. The five largest managed funds (Fidelity Magellan, Investment Company of America, Janus, Washington Mutual Investors and Fidelity Contrafund) have combined assets of $306.4 billion under management and an average expense ratio of 0.68 percent. That’s a full 0.5 percent more than the major index fund provider and a revenue difference of about $1.5 billion a year. Extend this idea to the average equity fund expense of 1.42 percent a year, and you can see that billions of dollars in investment fees are reinforced by a statistical quirk that is seldom discussed survival bias. Accounts Don’t Measure Up Question: We have assets (several hundred thousand dollars in a taxed account and three times that in tax-deferred accounts) invested in families of mutual funds. Our financial adviser suggests that we hire a group of money managers (one for value and one for growth) to manage our assets for us. The fee would be 2.5 percent of the amount invested per year, part of which goes to the investment house for acting as a liaison and monitoring the money managers. The managers would liquidate all or a part of our mutual fund assets and purchase equities in a diversified portfolio. Over a long period, is there a difference in the returns gained from a money manager investing in specific equities over our investing in a family of good-quality mutual funds such as America Funds, Putnam Funds, etc.? Are there sufficient tax issues (resulting from the need to pay capital gains tax annually on mutual fund gains vs. the deferral of capital gains taxes by holding individual securities) that there is an advantage to one investment design over the other? Are there ways to select a money manager other than using a brokerage firm as the liaison if the investor is naive in how to select and monitor the manager? And is 2.5 percent an appropriate fee? My wife and I are in our mid-50s and are hoping to continue working only another two to three years. L.B., San Antonio Answer: You’ve been offered a “wrap” account. Services are bundled and your money managed for an annual fee based on your assets rather than for fees based on transactions. In theory, this puts the broker on your side of the table because you no longer have the built-in conflict of interest over commissions. Unfortunately, the major brokerage houses accomplish this at the probable expense of future performance the fees are coming straight out of your investment return. They will, of course, protest that they have superior ability to pick money managers and that they will fire money managers who fail to perform. They might also imply that only through a firm as large as theirs could a miserable peasant a person like yourself, for instance have access to the brilliant minds that make gobs of money. Questions about personal finance and investments may be sent to Scott Burns, The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; or by fax: (214) 977-8776; or by e-mail: scott(at) scottburns.com. Check the Web site: www.scottburns.com. Questions of general interest will be answered in future columns.

Featured Articles

Related Articles