Survivor Bias – What Investment Managed Funds Are Hiding

Survivor Bias - managed stock investment fundsI believe that the best investment you can make is saving money and the easiest way to do it is through a simple investment plan. Part of that plan is using index funds to invest in stocks rather than managed funds. It seems a new report further confirms this as it seems that managed funds have a secret in the closet they’ve been hiding called Survivor Bias.

The difference between an actively managed fund and a passive fund (such as an index fund) is that one has a manager that uses his or her knowledge to pick stocks. For this service and knowledge, you pay a fee. Passive funds, on the other hand, simply follow an index and buy the exact same stocks in that index. Since there is nobody managing the fund, the fees are much lower.

Now it would seem to make sense to have a professional handle your stock picks from the outside, but in general the statistics say otherwise. It seems that the majority of managed funds, year in and year out, perform worse than the passive funds. That means you have a better than 50% chance (and more closely to 75%) that you’re paying more money for professional help to pick stocks that will earn you less money.

While this may seem bad, it is actually even worse because actively managed funds make their results look better through a nice little trick called Survivor Bias. Basically, when a managed fund is doing poorly, rather than record that poor performance, companies will usually conveniently merge the poor performing fund into another fund and all of a sudden the poor performance disappears. A recent report says that this “survivor bias” makes managed funds look on average 1.6% better each year than they really are – which in turn makes passive funds’ return in comparison that much better.

From the Zero Alpha Group news release:

According to the Savant Capital/ZAG study, when the little-understood “survivor bias” factor is taken into account, actively managed mutual funds in all nine of the Morningstar Principia “style boxes” lagged their related indexes for the 10-year period. In all but one of the 42 narrower Morningstar fund categories, the survivor bias effect worked to inflate fund returns. The Savant Capital/ZAG analysis also shows that the purging of the weakest funds from the Morningstar database boosted apparent returns on average by 1.6 percent per year from 1995-2004.

If you want to get into the nitty gritty of the report, you can read the full report from the Savant / Zero Alpha Group

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3 Responses to Survivor Bias – What Investment Managed Funds Are Hiding

  1. Scott says:

    Excellent article. It explains how every fund company can claim to have top performing funds without lying. Just merge the non-performing ones, and “poof”, now every fund is great. Just one more confirmation if you’re not investing in a deferred tax account, as long as you do a little due dilligence, and not try to get greedy, you’re better off fending for yourself.

    It also explains how the little DRIPs I do own have performed much better than my 401(k)s. Its a shame these deferred accounts don’t allow you to buy and sell individual stocks. (I’m talking about going through an employer, not an IRA)

  2. sue says:

    you may want to put more money into a ROTH IRA or traditional IRA so you can buy and sell individual stocks or buy ETF’s.

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