What’s a Survivorship Bias?
When a mutual fund performs terribly, it doesn’t typically attract new investors and many of its current customers flee the fund for healthier pastures. Often, the poorly performing fund is merged with another fund or it is shut down.
In November 2009, I underwent bone cancer surgery—where large pieces of three of my ribs were removed, as well as chunks of my vertebrae. But you want to know something? My five-year survivorship odds were better than that of the average mutual fund. Examining two decades of actively managed mutual fund data, investment researchers Robert Arnott, Andrew Berkin, and Jia Ye tracked 195 actively managed funds before reporting that the funds had a 17 percent mortality. According to the article they published with the Journal of Portfolio Management in 2000 called “How Well Have Taxable Investors Been Served in the 1980s and 1990s?,” 33 of the 195 funds they tracked disappeared between 1979 and 1999.14 No one can predict which funds are going to survive and which won’t. The odds of picking an actively managed fund that you think will survive are no better than predicting which bone cancer survivor will last the longest.
When the Best Funds Turn Malignant
You might think that the very best funds (those with long established track records) are large enough and strong enough to have a predictable longevity. They can’t suddenly turn sour and disappear, can they?
That’s what investors in the 44 Wall Street Fund thought. It was the top-ranked fund of the 1970s—outperforming every diversified fund in the industry and beating the S&P 500 index for 11 years in a row. Its success was temporary, however, and it went from being the best-performing fund in one decade to being the worst-performing fund in the next, losing 73 percent of its value in the 1980s. Consequently, its brand name was mud, so it was merged into the Cumberland Growth Fund in 1993, which then was merged into the Matterhorn Growth Fund in 1996. Today, it’s as if it never existed.15
Then there was the Lindner Large-Cap Fund, another stellar performer that attracted a huge following of investors as it beat the S&P 500 index for each of the 11 years from 1974 to 1984. But you won’t find it today. Over the next 18 years (from 1984 to 2002) it made its investors just 4.1 percent annually, compared with the 12.6 percent annual gain for investors in the S&P 500 index. Finally, the dismal track record of the Lindner Large-Cap Fund was erased when it was merged into the Hennessy Total Return Fund.16
You can read countless books on index-performance track records versus actively managed funds. Most say index funds have the advantage over 80 percent of actively managed funds over a period of 10 years or more. But they don’t typically account for survivorship bias (or taxes, which I’ll discuss later in this chapter) when making the comparisons. Doing so gives index funds an even larger advantage.
When accounting for fees, survivorship bias, and taxes, most actively managed mutual funds dramatically underperform index funds.
Mark Kritzman is president and chief executive of Windham Capital Management of Boston. He also teaches a graduate course in financial engineering at M.I.T.’s Sloan School of Management. In 2009, he calculated that the typical actively managed mutual fund, in a taxable account, would have to beat an index fund by an average of 4.3 percent per year, before fees and taxes, just to break even with an index fund. The New York Times reported his study in 2009.17
Holes in the Hulls of Actively Managed Mutual Funds
There are five factors dragging down the returns of actively managed US mutual funds: expense ratios, 12B1 fees, trading costs, sales commissions, and taxes. Many people ask me why they don’t see these fee liabilities mentioned on their mutual fund statements. With the possible exception of expense ratios and sales commissions—in very small print—the rest are hidden from view. Buying these products over an investment lifetime can be like entering a swimming race while towing a hunk of carpet.
1. Expense Ratios
Expense ratios are costs associated with running a mutual fund. You might not realize this, but if you buy an actively managed mutual fund, hidden fees pay the salaries of the analysts and/or traders to choose which stocks to buy and sell. These folks are some of the highest paid professionals in the world; as such, they are expensive to employ. There’s also the cost of maintaining their computers, paying office leases, ordering the paper they shuffle, using electricity, and compensating the advisers/salespeople for recommending their funds.
Then there are the owners of the fund company. They receive profits based on the costs skimmed from mutual fund expense ratios. I’m not referring to the average Joe who buys fund units in the mutual fund. I’m referring to the fund company’s owners.
A US fund that holds a collective $30 billion would cost its investors (the average Joe) about $450 million every year (or 1.5 percent of its total assets) in expense-ratio fees. That money is sifted out of the mutual fund’s value. But it isn’t itemized for investors to see.18 And the cash comes out whether the mutual fund makes money or not.
2. 12B1 Fees
Not every actively managed fund company charges 12B1 fees, but roughly 60 percent in the United States do. They can cost up to 0.25 percent, or a further $75 million a year for a $30 billion fund. These pay for marketing expenses including magazine, newspaper, television, and online advertising that’s meant to lure new investors. That money has to come from somewhere. So current investors pay for new investors to join the party.19 It’s like a masked phantom pulling money from the wallets of mutual fund investors every night. Financial advisory statements don’t itemize these expenses either.
3. Trading Costs
A third fee includes the fund’s trading costs. They fluctuate year to year, based on how much buying and selling the fund managers do. Remember, actively managed mutual funds have traders at the helm who buy and sell stocks within the fund to try and gain an edge. But on average, according to the global research company Lipper, the average actively managed stock market mutual fund accrues trading costs of 0.2 percent annually, or $60 million a year on a $30 billion fund.20 The costs of trading, 12B1 fees, and expense ratios aren’t the only invisible albatrosses around the necks of mutual fund investors.
4. Sales Commissions
If the three hidden fees above are bringing you back in time to the nightmarish bottom of an elementary school dog pile, I have worse news for you. Many fund companies charge load fees: either a percentage up front to buy the fund (which goes directly to the salesperson) or a fee to sell the fund (which also goes directly to the salesperson). These fees can be as high as 6 percent. Many financial advisers love selling “loaded funds,” which add a pretty nice kick to their own personal accounts. But they aren’t such a great deal for investors. A fund charging a sales fee of 5.75 percent, for example, has to gain 6.1 percent the following year just to break even on the deposited money. That might sound like strange math at first, but if you lose a given percentage to fees, you have to gain back a higher percentage to get your head back above water. For example, losing 50 percent in one year (turning $100 into $50) ensures that you will need to double your money the following year to get back to the original $100. Advisers choosing loaded funds for their clients put a whole new spin on “Piggy Bank,” don’t you think?
5. Taxes
More than 60 percent of the money in US mutual funds is in taxable accounts.21 This means when an actively managed mutual fund makes money in a given year, the investor has to pay taxes on that gain if the fund is held in a taxable account. There’s a reason for that. Actively managed stock market mutual funds have fund managers who buy and sell stocks within their funds. If the stocks they sell generate an overall profit for the fund, then the investors in that fund (if they hold the fund in a taxable account) get handed a tax bill at the end of the year for the realized capital gain. The more trading a fund manager does, the less tax efficient the fund is.
In the case of a total stock market index fund, there’s virtually no trading. The gains that are made on the stocks held don’t generate
a taxable hit for the funds’ investors unless the investor sells the fund at a higher price than he or she paid. Rather than paying a high rate of capital gains tax every year, the index investor is able to defer his or her gains, paying them when he or she eventually sells the fund. Doing so allows for significantly higher compounding profits.
Mutual fund managers know that few people are going to compare their “after-tax” results with other mutual funds. For example, a fund making 11 percent a year might end up beating a fund making 12 percent a year—after taxes.22 What makes one fund less tax efficient than another? It’s the frequency of their buying and selling. The average actively managed mutual fund trades every stock it has during an average year. This is called a “100 percent turnover.”23 The trading practices of most mutual fund managers trigger short-term capital gains to the owners of those funds (when the funds make money). In the United States, the short-term capital gain tax is a hefty penalty. But few actively managed fund managers seem to care.
In comparison, index-fund investors pay far fewer taxes in taxable accounts because index funds follow a “buy and hold” strategy. The more trading that occurs within a mutual fund, the higher the taxes incurred by the investor.
In the Bogle Financial Markets Research Center’s 15-year study on after-tax mutual fund performances (from 1994 to 2009), it found actively managed stock market mutual funds were dramatically less tax efficient than a stock market index. For example, if you had invested in a fund (for your taxable account) that equaled the performance of the stock market index from 1994 to 2009, you would have paradoxically made less money than if you had invested in an index fund. But why would you have made less money if your fund had matched the performance of the stock index?
Before taxes, if your fund matched the performance of the US index, you would have averaged 6.7 percent per year. After taxes though, for the actively managed fund to make as much money as a US index fund, it would have needed to beat the index by a total of 16.2 percent over the 15-year period. This is assuming that the mutual fund manager bought and sold stocks with a regularity that equaled the average actively managed fund “turnover.”24
Let’s look at an actively managed fund with a track record of strong performance and low portfolio turnover (remember that performance is rarely sustainable). Fidelity’s Contrafund (FCNTX) fits the bill. When I accessed Morningstar, mid-2016, the fund ratings company posted the Fidelity Contrafund’s turnover at just 35 percent. That’s good. It’s far below the industry average. It means that the fund would have traded just 35 percent of its holdings the previous year.
By April 30, 2016, Fidelity’s Contrafund had earned an average pre-tax annual compound return of 11.57 percent over the previous three years. This beat the pre-tax return of Vanguard’s S&P 500 index. It averaged 11.09 percent per year during the same time period. But the index fund’s taxable turnover was just 3 percent. This gave it an after-tax advantage.
Morningstar estimated that the Fidelity Contrafund’s three-year, post-tax performance was 9.82 percent per year. Vanguard’s S&P 500 index did better. It averaged an estimated post-tax compound annual return of 10.38 percent per year.25
A post-tax comparison of a mutual fund’s performance against the performance of a stock market index isn’t something that you will likely see on a typical mutual fund statement. But the post-tax gain is the only number that should count. This also applies to Canadians and those of other nationalities who invest in taxable accounts.
Adding high expense ratios, 12B1 fees, trading costs, sales commissions, and taxes to your investment is a bit like a boxer standing blindfolded in a ring and asking his opponent to hit him five times on the jaw before the opening bell. It’s tough to put up a fair fight when you’re already bleeding.
Figure 3.1 illustrates that if you learned this in school, it’s likely that you would never consider investing in actively managed funds as an adult.
Figure 3.1 Five-Star Funds vs. Total Stock Market Index (1994–2004)
Source: John C. Bogle, The Little Book of Common Sense Investing
The Futility of Picking Top Mutual Funds
You’ve just told your financial adviser that you’d like to invest in index funds—and now she’s desperate. She won’t make money (or not much) if you invest in indexes. It’s far more lucrative for advisers to sell actively managed mutual funds instead. She needs you to buy the products for which she will be compensated handsomely, so here’s the card she plays:
“Look, I’m a professional. And our company has access to researchers who will help me choose actively managed funds that will beat the indexes. Just look at these top-rated funds. I can show you dozens of them that have beaten the stock market index over the past 10 years. Of course I would only buy you top-rated funds.”
Are there dozens of funds that have beaten the stock market indexes over the past 5, 10, or 15 years? Sure there are. But those funds, despite their track records, aren’t likely to repeat their winning streaks. Mutual fund investing is a rare example of how, paradoxically, historical excellence means nothing.
Reality Check
Morningstar is an investment-research firm in the United States that awards funds based on a five-star system: five stars for a fund with a remarkable track record, all the way down to one star for a fund with a poor track record. Five-star funds tend to be those that have beaten the indexes over the previous five or ten years.
The problem is that fund rankings change all the time, and so do fund performances. Just because a fund has a five-star rating today doesn’t mean that it will outperform the index over the next year, five years, or 10 years. It’s easy to look back in time and see great performing funds, but trying to pick them based on their historical performance is an expensive game.
Academics refer to something they call “reversion to the mean.” In practical terms, actively managed funds that outperform the indexes typically revert to the mean or worse. In other words, buying the top historically performing funds can end up being the kiss of death.
If an adviser had decided to purchase Morningstar’s five-star rated funds for you in 1994, and if he sold them as the funds slipped in the rankings (replacing them with the newly selected five-star funds), how do you think the investor would have performed from 1994 to 2004 compared with a broad-based US stock market index fund?
Thanks to Hulbert’s Financial Digest, an investment newsletter that rates the performance predictions of other newsletters, we have the answer. It’s emphasized in Figure 3.1.
One hundred dollars invested and continually adjusted to only hold the highest rated Morningstar funds from 1994 to 2004 would have turned into roughly $194. It would have averaged 6.9 percent per year in a tax-deferred portfolio.
One hundred dollars invested in a broad-based US stock market index from 1994 to 2004 would have turned into roughly $283. It would have averaged 11 percent per year in a tax-deferred portfolio.26
Many investors invest more than what their tax-deferred accounts will allow each year. To do so, they must invest in a taxable account. In such accounts, the after-tax performance difference between an actively managed fund and an index grows even wider. You might as well be running with a monkey on your back.
One hundred dollars invested and continually adjusted to hold only the highest rated Morningstar funds from 1994 to 2004 would have turned into roughly $165 in a taxable account. After taxes, it would have averaged 5.15 percent per year.
One hundred dollars invested in a broad-based US stock market index from 1994 to 2004 would have turned into roughly $271 in a taxable account. After taxes, it would have averaged 10.5 percent per year.
Interestingly, more than 98 percent of invested mutual fund money gets pushed into Morningstar’s top-rated funds.27
But choosing which actively managed mutual fund will perform well in the future is, in Burton Malkiel’s words, “. . . like an obstacle course through hell’s kitchen.”28 Malkiel, a professor of economics at Princeto
n University and the bestselling author of A Random Walk Guide to Investing, adds:
There is no way to choose the best [actively managed mutual fund ] managers in advance. I have calculated the results of employing strategies of buying the funds with the best recent-year performance, best recent two-year performance, best five-year and ten-year performance, and not one of these strategies produced above average returns. I calculated the returns from buying the best funds selected by Forbes magazine . . . and found that these funds subsequently produced below average returns.29
Studies routinely show that you can’t pick winning mutual funds based on how they performed last month, last year, or over the past decade. Funds that win during one time period usually get thumped the next.
The SPIVA Persistence Scorecard gets published twice a year. It looks at actively managed funds that are among the top 25 percent of performers. Then it determines what percentage of those funds remains among the top 25 percent of performers. There were 682 US stock market funds among the top 25 percent of performers as of March 2013. By March 2015, just 5.28 percent of them remained among the top quartile. Look for these reports every six months. They always present a similar eye-opening tale.30
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