Accounting for failure

December 30, 2016

Nothing attracts more investors like the alluring narrative of sizable, past returns. Indeed, money comes flooding in when a fund manager beats the market by even the slightest margin, despite the improbability of repeat outperformance. Despite the narrative in the media that all investment advisors, hedge fund titans, and general money managers are impervious to failure, the truth plays out every year with a considerable number of funds being consigned to the dustbin of history. But rarely are these failures reported, let alone accounted for, when it comes time to publish the investment community’s holy grail of marketing: past performance. There’s a term for this lack of accountability when it comes to measuring and reporting how well investment professionals did over any given year and it’s called survivorship bias.

 

Conveniently forgotten

 

Survivorship bias is basically the effect of bad data. But to be more precise, it’s the result of leaving out all the “dead” funds in the data of past performance, essentially skewing the data to the upside, giving the investor an incorrect perception of higher past returns. Just like any other profession, not everyone can be above average; this is a logical certainty. Investment experts are no different, and many simply fail to attract outside capital or produce decent returns or even get off the ground from the outset of the fund’s inception. The good news is the data for conveniently forgotten funds is available, the bad news is your investment advisor or fund prospectus may not be so apt to disclose this information. 

 

Take the five years ended December 31, 2011, for example. Data from Vanguard Research indicate that for large-cap value funds, 62% outperformed their benchmark index. But this doesn’t take into effect those funds that went out of business during that time period. Accounting for those funds would reduce this outperformance percentage to 46%.1 With less than a 50% chance of selecting a winning fund manager, it’s no surprise that many people have turned to passive investing. And the longer the time period, the more incidents of liquidation occur, which skew the data even further. Marketing executives within the fund industry are loath to disclose long-term performance because the longer these money managers are in the business, the more difficult it becomes to consistently beat the market. And broadcasting failure is bad for business.

 

If you take the fifteen years from January 1, 1997 to December 31, 2011, investors had just a 22% chance of picking a fund (or fund manager for that matter) that survived, outperformed, or was merged with another fund and resulted in outperformance.2 A less than one-in-four chance of picking a winning fund manager is not the sort of data that entices investors to part with their hard-earned money. 

 

Actively beating a dead horse

 

There are two schools of investment thought: active investing attempts to “actively” beat a particular benchmark index after incurring substantial costs to do so, while passive investing endeavors to match benchmark returns by incurring minimal costs. 

 

For a visual depiction of the survivorship bias phenomenon, Figure 1 highlights the underperformance of actively managed funds over a 10-year period ended December 31, 2013. Actively-managed funds lost to passively-managed index funds on average about 75% of the time for each of the five asset classes listed below. Moreover, there’s a 5 to 20 basis point gap between surviving fund performance versus non-surviving funds, as depicted from the graph.3

 

 

Figure 1. Active mutual fund underperformance, for the 10-year period ended December 31, 2013

 

Nowhere is active management more prevalent than in the hedge fund industry. The sole purpose of hedge fund managers is to produce superior performance no matter the timeframe or the general trend of the market, and they’re paid lots to do it. But oftentimes, the exact opposite happens. In 2015, hedge funds as a whole, measured by hedge fund research firm HFR, Inc., lost more than 3%, while the S&P 500 returned 1.4%, including dividends.4 

 

The HFRI Fund Weighted Composite Index is an index of hedge funds, which is used to gauge how the industry as a whole is doing against its competition. The index is down against the S&P 500 by 3% annually over the last ten years.5 

 

The Buffett bet

 

Proponents of hedge funds will point out that the HFRI Composite Index is merely an average and there are many funds that have outperformed the S&P 500 over these past ten years. There are undoubtedly many funds that have beat the S&P, and that’s probably why a money management firm by the name of Protégé Partners could not sit idle and watch the hedge fund industry not defend itself. They made a million-dollar bet with Warren Buffett (proceeds donated to charity) that they could pick five of the best “funds of funds” (i.e. a collection of hedge funds within a fund), and it would beat the fund selected by Buffett: a basic S&P 500 index fund.

 

The ten-year wager was made at the beginning of 2008, so there’s still some time left, but to date Buffett’s index fund is up 65%; Protégé’s hedge fund picks are up only 22%. Even the greatest active investor of all time sees the value in indexing, and unlike actively-managed mutual funds, hedge funds, and exchange-traded funds, survivorship bias is not a factor since an index fund as large and enduring as the S&P 500 is not going to liquidate any time soon. 

 

 

 

1. Vanguard Research. The Mutual Fund Graveyard: An Analysis of Dead Funds, January 2013.

2. Vanguard Research. The Mutual Fund Graveyard: An Analysis of Dead Funds, January 2013.

3. Notes: The actively managed funds are those listed in the respective Morningstar

categories. Index funds are represented by funds with expense ratios of 20 basis points

or less as of December 31, 2013. All returns used were for the investor share class. Data reflect

the ten-year period ended December 31, 2013. Sources: Vanguard and Morningstar, Inc.

4. Copeland, Rob. Wall Street Journal. Wasted Opportunity: Hedge Funds Falter, January 1, 2016

5. Kaissar, Nir. Hedge Funds Have a Performance Problem, Bloomberg March 2016

 

 

 

 

 

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