Survivorship Bias

Often times, poorly performing funds are liquidated or merged into a better-performing fund. The vast majority of mutual fund reporting services do not account for this survivorship bias. Funds that no longer exist are not included in category average returns. When there are only a modest or moderate number of funds in a category, historical returns can end up looking far better than what investors actually experienced.

For example, by the end of 1996, there were six market-neutral or long-short funds. Over the subsequent 10 years, 62 more were added. By the middle of 2012, only 32 were left. Today’s long-short funds in existence in 2003 had an average return of 19.2% that year; but back in 2003 (before the laggards went out of business), the typical long-short fund returned just 8.5% (source: Morningstar).

Using Morningstar data through July 31, 2012, the average 15-year return for market-neutral and long-short funds went from an annualized 5.4% down to 1.7% a year (once survivorship bias was eliminated). In order to eliminate this hindsight “bias,” advisors should look at year-by-year category figures from Morningstar. These average annual numbers do not change due to subsequent liquidations or mergers. Numbers shown in parentheses below are adjusted so that survivorship bias is eliminated.

Return Figures: Standard vs. Adjusted For Survivorship Bias

[annualized returns for long-short and market-neutral funds]

                    Source:  Morningstar data through 7-31-2012; numbers in parentheses are adjusted

Obviously, categories that include 75-100 or more mutual funds are less affected by survivorship bias. The next table shows the status (as of August 2012) of long-short and market-neutral funds that began operations from 1997 through 2006.

Return Figures: Standard vs. Adjusted For Survivorship Bias

[annualized returns for long-short and market-neutral funds]

              Source: Morningstar