Survivorship bias: Why you’re not seeing the full picture when it comes to fund management performance

Wouldn’t it be great if every time you made a poor decision in life, you could just rewind and erase it? As it turns out, this actually happens in the fund industry. If a unit trust performs poorly and shuts down, it’s booted from peer average calculations as you can no longer invest in it. The historical performance you’re looking at only reflects the ‘survivors’, which means that the average performance figures are probably rosier than they would be if the funds that crashed and burned were included.

Survivorship bias can be found everywhere.

• During WWII, the British military wanted to learn how to best protect their planes from enemy gunfire. They focused on reinforcing areas of the planes that returned to base with the most bullet holes, as they reasoned that the bullet holes showed where these planes were getting hit. Hungarian mathematician Abraham Wald saw the fallacy in this - they should instead reinforce areas where the surviving planes weren’t getting hit. The planes could clearly survive a strike on those points riddled in bullet holes.
• Long Term Capital Management (LTCM) was a hedge fund that nearly brought down the global financial system. A leading index of hedge fund data contained LTCM’s data prior to its collapse, which had an annualized return of 32.4% from inception in Mar 1994 to Oct 1997. This inflated the hedge fund industry’s overall results given LTCM’s size. LTCM stopped reporting data from Oct 1997 until its demise a year later, when the fund lost 91.8% of its capital and was eventually liquidated.

Perhaps it would not be such a big deal in the investment landscape if only a minority of funds closed down and this was just a marginal trend.

Unfortunately, you may be surprised by how many unit trusts become obsolete over time.

Not accounting for closed funds lead to Survivorship Bias

Survivorship bias can be quite significant for the long-term investor because it can distort performance figures. As you can see, less than half of the equity funds and 57% of the bond funds survived over the 15-year period. Taking into account all those funds that vanished would paint a very different picture from the ‘average’ fund returns.

Vanguard published a research paper titled ‘The Mutual Fund Graveyard’, which concluded that ‘not accounting for closed funds can lead to a false perception of the probability of success.’ For example, for the five years ending on December 31, 2011, 62% of surviving large-cap value funds outperformed their style benchmark. However, accounting for those funds that closed would reduce that percentage to just 46%.

This analysis swings our perception from optimistic about the ability to pick a fund manager who can beat their benchmark, to feeling cheated, with the odds no longer in our favor.

We cannot analyze the planes that were shot down and decaying at the bottom of the ocean, but what we can do is be aware of survivorship bias and understand the limitations in looking at historical data when investing.