Mutual-Fund Math Puts A Sheen on Returns
'Survivorship Bias' Calculation Makes Bad Performances Vanish;
Industry Group Has No Position

July 23, 2004; Page C1

The average returns of stock mutual funds are often underwhelming. Turns out, they are also overstated.

The track records of mutual funds that are either merged into other funds or liquidated are erased from the databases that fund companies and the media generally use to measure performance. Like a kid's unwanted drawing on an Etch A Sketch, they vanish, leaving only the records of so-called survivor funds, usually those with better returns, more assets and lower expenses.

This practice, largely unknown to the nation's more than 91 million fund investors, is called "survivorship bias." And it is likely getting worse due to an increase in fund mergers and liquidations since the stock-market bubble burst.

Check long-term U.S. stock-fund returns with Lipper Inc., for example, and you would see they averaged a 9.7% annualized gain in the past decade, compared with 11.3% for Standard & Poor's 500-stock index. But the Lipper figure ignores the records of many failed funds. Including them would shave more than a percentage point off the average return.

"The fact is that what we think of as the typical mutual fund's returns are grotesquely overstated," says John C. Bogle, founder of mutual-fund company Vanguard Group, Malvern, Pa.

For the 10 years ended in 2003, the difference amounts to 1.6 percentage points, according to the Center for Research in Security Prices at the University of Chicago; it calculated an average annual gain of 8.8% using only surviving U.S. stock funds, and 7.2% counting funds that no longer exist. For the past 40 years, the center says the average annual gain for surviving funds was 11%, compared with 9.4% when "dead" funds are counted too.

If these differences don't sound like much, consider that a $10,000 investment earning 11% annually for 40 years grows to more than $650,000, while the same investment earning 9.4% reaches $363,657. The difference in return was even larger for sector funds, where the center found a 7.5% annual gain for "live" funds during the past five years, compared with a 4.4% gain if dead ones are included.

"It's definitely misleading to look at only live funds' returns," says Eugene Fama, a finance professor and researcher at the University of Chicago. "It's a pervasive problem in fund-performance reporting."

The difference can lead to very different conclusions about the value of actively managed funds. In the five years ended June 30, for example, 60% of actively managed funds focused on large-company stocks beat the S&P 500, according to Standard & Poor's, which provides data to the University of Chicago. But if the returns of funds that were merged or liquidated are included, fewer than half topped the index.

"If you don't account for this, you might think most managers beat the index, but when you account for survivorship bias the opposite is true," says Srikant Dash, a fund analyst with S&P.

The problem may be getting worse as the glut of stock-fund launches in the 1990s, particularly of technology and other sector-focused funds, has led to a spate of fund mergers and liquidations. For the past three years, an average of 830 funds a year have disappeared, nearly double the average for the previous three years, according to AMG Data Services of Arcata, Calif., which counts different share classes as individual funds. The number of technology funds has fallen to 120, from 176 at the end of 2001, says Boston fund consulting firm Financial Research Corp.

Academics have grappled with, and written about, survivorship bias for years as they fretted about its impact on their studies of fund returns. But most investors have likely never heard of the issue.

"I think if you asked most investors about survivorship bias, they'd point to the TV show," says Phil Edwards, a managing director of S&P's global funds research unit.

For its part, the industry is aware of the problem. "We're all comparing funds among groups of survivors," says Jim Atkinson, president of Guinness Atkinson Funds. "By definition they'll tend to be better performers."

The bias came about because research firms such as Lipper and Morningstar Inc. traditionally discarded dead funds' records since investors and financial advisers used their databases to research live funds. Both say that, if asked, they can get recent data on dead funds. Lipper fund analyst Andrew Clark says a few of the firm's institutional clients have begun asking for data that includes these funds.

A spokesman for the Investment Company Institute, the fund-industry trade group, says its economists are aware of the issue -- they include dead funds in their studies of fund fees -- but the group doesn't have "a policy position" on it.

Some analysts complain that mergers and liquidations essentially give fund companies a chance to edit their performance after the fact. In a merger, if the surviving fund has a better record, the firm's overall performance looks stronger.

A fund that ceases to exist disappears entirely. "It's clear the fund companies kill off bad funds to make themselves look better and also because they simply can't sell dogs," says Russell Kinnel, director of fund research at Morningstar.

But survivors don't always look healthy either. The John Hancock Large Cap Growth Fund, for example, has swallowed three struggling growth funds in the past decade. In that time, it has eked out an average annual return of 2%, trailing 99% of the nation's large-cap-growth funds, according to Morningstar. The company didn't return calls seeking comment.

Some argue that since many funds that vanish are small, it makes more sense to count live, larger funds that better represent the average investor's experience. That said, some funds that go away are actually quite large. After the PaineWebber Strategy Fund raised a whopping $2.1 billion in its November 1999 launch, for instance, it trailed both its peers and the S&P 500. In 2003, a few years after PaineWebber was acquired by UBS AG, the fund merged into the far smaller and better-performing UBS Global Equity Fund, wiping the Strategy fund's record off the books.

UBS spokeswoman Christine Walton says the UBS Global Equity Fund survived because the firm chose its investment approach over the PaineWebber fund's. Still, many fear that discarding the returns of, and lessons learned from, failed funds is a bad idea that misleads investors.

"You shouldn't be able to rewrite history," says S&P's Mr. Edwards. "My grade-point average would look a lot better if I took out my failing grades, wouldn't it?"

Write to Ian McDonald at