Have You Been Misled by Returns Information?

There are lots of fairy tales told about mutual fund performance. Today, we'll look at some of the most common, including one that has a new study out measuring its effect.

Survivorship Bias One way to create a fairy tale is to show the performance of only those funds that are currently in existence. This is known as "survivorship bias." Funds that have poor performance disappear, most often by merging a poorly performing fund into a better performing one. Unfortunately, only the performance reporting disappears, not the poor returns.

A classic example involves mutual fund information company Lipper. In 1986, Lipper reported that 568 stock funds had an average return of 13.4 percent. However, in 1997, Lipper showed the 1986 return to be 14.7 percent. This happened because 134 funds from the original batch disappeared, and their returns were removed from the database. Fortunately, we now have publicly available databases for mutual funds that are free of survivorship bias.

Bad Comparisons Another fairly well-known way to present performance figures in a misleading fashion is to compare returns to an inappropriate benchmark. For example, a private equity fund, hedge fund or even a value fund might compare its returns to the S&P 500 Index. Each of these funds takes on much greater risk than that benchmark, including the use of leverage. Thus, their returns should be compared to more appropriate, risk-adjusted benchmarks. Many investors have been fooled by this trick.

Incubator Bias There's a third, less well-known bias in mutual fund reporting called incubator bias. Here's a hypothetical example: A mutual fund company uses its own capital to seed multiple small-cap funds. Each fund might own a different group of small-cap stocks. The fund family incubates the funds, safe from public scrutiny. After a few years they bring public only the fund with the best performance. Magically, the poor performance of the other funds disappears, never to see the light of day.

Unfortunately, the SEC allows fund families to report the pre-public performance of these incubator funds. Thus, we have the potential for a huge distortion of reality, as only successful fund histories make it into the public databases. This is a real problem since the historical evidence is that the past performance of mutual funds has proven not to be prologue.

Richard Evans has done the first major study on mutual fund incubator bias. His study covered the 10-year period 1996-2005. The following is a summary of his findings:

• Almost 25 percent of new funds were incubated.
• To boost potential returns, these funds took on more risk in the incubation period than after they emerged. Not only did they invest in riskier assets, but they took more idiosyncratic risk. (They have more concentrated portfolios, increasing the potential dispersion of returns.)
• Funds in incubation outperformed non-incubated funds by 3.5 percent per year on a risk-adjusted basis.
• Incubated funds attracted higher net-dollar flows, as the public believed these are superior funds.
• Post-incubation, however, the outperformance disappears.
• The performance reversal imparts an upwards bias to returns that isn't removed by a fund size filter. (Incubator funds are typically very small.)
• The bias results in risk-adjusted alphas being overstated by 0.43 percent. On an equal-weighted basis, the bias overstates returns by 0.84 percent.

More on MoneyWatch:
Equity-Like Returns with Bond-Like Risk? Not So Fast! Beware of Broker Biases Even Similar Funds Can Have Very Different Returns When Dollar-Cost Averaging Makes Sense When Dollar-Cost Averaging Doesn't Make Sense
Hear Larry Swedroe discuss current investment trends and topics every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. Can't catch the show? Download the podcast via www.investmentadvisornow.com or through the Buckingham Asset Management podcast page on iTunes.