Back to Basics and Mutual Fund Survivorship Bias

May 1, 2009 by  
Filed under Investing

We have friends visiting this weekend – the “went to high school together – stood up at your wedding – still likes you after 44 years” kind of friends that everyone should be so lucky to have. So I am not spending a lot of time writing. (I’m sneaking this in during visitors’ nap time.)  It’s back to the basics of doing what is most important in life, and talking about money is getting outranked right now.

I will throw one tip your way about getting back to investing basics.  Scott Burns wrote a compelling article on the value (or lack of same) of professional money managers and their actively managed funds vs. index funds. This nugget from Burns’ piece should get your attention:

A majority of the randomly selected portfolios delivered higher returns than the pros. Like the earlier studies of institutional portfolios that led to the first institutional index fund, about 70 percent of the automated monkeys beat the pros.

“Survivorship bias” is an important but often overlooked factor when broadly comparing mutual fund types. Even Morningstar gets it wrong in reporting its data. You need to get it right to truly understand what you are being told about the relative success of actively managed funds. Simply put, survivorship bias is a method of reporting mutual fund investment performance in which the worst performing funds are ignored. The reason they are ignored is that they don’t survive. This bias is not insignificant when you consider that in any five year period, one in four funds disappear because they were terrible performers. It is easy to skew the performance data for managed funds in a favorable direction when only the funds that survive are included.

I’m not suggesting that all money managers are monkeys, but if you have a 401(k) plan with high cost managed funds and lower cost index fund alternatives, carefully consider the data referenced in Burns’ article.

Enjoy your weekend. I know that we will.

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2 Responses to “Back to Basics and Mutual Fund Survivorship Bias”
  1. doctor S says:

    I am young and inexperienced on the topic. I read up as much as I can, esp with all the resources I have at my company, being a Financial Firm. I still am trying to find the value in the actively managed funds over the index funds. I will take consistent returns over time with low fees any day over the higherpriced riskier choices. My comments may advertise my lack of knowledge on the subject, but to me it seems like a no-brainer, esp in the current economic climate we are experiencing.

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