How the mutual fund graveyard can hurt investors

The tendency for mutual fund companies to drop poorly performing funds when calculating historical return data is a major problem for unsuspecting investors, and it's known as survivorship bias. An investor selecting mutual funds today is choosing from a list that excludes the losers that have been either closed or merged out of existence so that their poor returns disappear.

For example, Morningstar reported that of all the traditional U.S. mutual funds operating in 2004, 40 percent had shut down before 2014. Perhaps even more surprising, Morningstar also found that of the funds it rated five-stars in 2002, 20 percent didn't survive the decade. And an astonishing 61 percent of the one-star funds survived the full 10 years.

Death abounds

According to John Bogle, legendary founder of Vanguard Group, around 7 percent of mutual funds "died" each year between 2001 and 2012. That's up from about 1 percent per year during the 1960s.

In digging through my files, I found the following data that demonstrate just how big a problem survivorship bias is:

1) In 2003, 870 U.S. mutual funds were merged into other funds, and 464 were liquidated -- 1,334 funds had their records magically erased.

2) In 2002, the pace was similar, with 839 mergers and 555 liquidations, for a total of 1,394 what we might call "mercy killings."

3) And 2001 saw 956 mergers and 433 liquidations, for a total of 1,389 "executions."

Not only was the death rate amazingly persistent, but that's a three-year total of 4,117 funds that went out of existence. Think carefully about that figure, and compare it to the total of 7,596 mutual funds that were available to investors at the end of 2012.

Now, contrast this track record with the death rate for Vanguard's index funds or Dimensional Fund Advisor's group of structured portfolios. (Full disclosure: My firm Buckingham recommends Dimensional funds in constructing client portfolios.) I'm not aware of any of their funds being sent to that mutual fund graveyard because of poor performance.

Cause of death: Underperformance

Understanding how survivorship bias affects the odds of success in selecting actively managed funds that will outperform in the future is an important issue. Vanguard's research department looked at this problem in a study that covered the period 1997-2011. I believe many investors will be surprised at how big a problem survivorship bias is. Here's a summary of the findings:

• Just 54 percent of the funds managed to even survive the full 15 years. The rest (2,364 funds) were either liquidated or merged into another fund in the same fund family, in some cases more than once.
• As you would expect, the leading cause of fund failure was underperformance. Funds that failed were experiencing negative cash flows at the time of closure, as investors responded to the poor performance.
• Investors had a 79 percent chance of picking a fund that underperformed, was liquidated or had a life cycle that was too convoluted for them to disentangle. For large growth funds, the odds of failure were even higher, at 82 percent. For large value funds it was slightly better, at 73 percent.

Note that all of these data are based on pretax returns. Since the higher turnover rates of actively managed funds tend to make them more tax-inefficient, on an aftertax basis the odds of success would be much worse.

Vanguard also specifically looked at what happened to stock funds that were merged, rather than closed. Following the merger, 73 percent underperformed. Accounting for both pre- and post-merger periods, 87 percent of funds underperformed for the full 15 years. In seven of the fund categories, at least 99 percent of these merged funds underperformed.

For bond funds, the data are even worse. For government bond funds, the failure rate was 89 percent, for corporate bond funds it was 99 percent, and for high-yield funds it was 100 percent. Clearly, while merging a poorly performing fund might provide hope for the investor, it doesn't improve the odds of outperforming in the future.

A costly improvement

Investors who seek outperformance through active fund manager selection have another problem. If a fund closes at a time when its value is above the investor's cost basis, the investor will be forced to pay capital gains taxes that otherwise might have been delayed or even avoided altogether (due to the potential for what is called a step-up in basis upon fund death).

Vanguard's findings confirm that of prior research. For example, a study by Lipper found the following: In 1986 the then-existing 568 stock funds returned 13.4 percent. By 1996, the 1986 performance had magically improved to 14.7 percent. The 1.3 percentage-point improvement resulted from the disappearance of 24 percent of the original funds and because only the 1986 performance of the funds still in existence 10 years later was used in the new computation.

Hedge funds plagued as well

Survivorship bias is even a bigger problem in the world of hedge funds. One study found that survivorship bias in the reported data on hedge fund returns creates an upward bias of 4.4 percent per year. The same study found a substantial attrition rate -- less than 25 percent of the funds in existence in 1996 were still alive in 2004.

The difference in returns between the live and defunct funds exceeded 8 percent per year (13.7 percent versus 5.4 percent). Another study found that the median life of a hedge fund is just 5.5 years.

The bottom line

Evidence makes clear that while it's possible to choose actively managed funds that will outperform, the odds of doing so are so poor that it isn't prudent to try.

Poking more holes in the active approach is that investors don't build portfolios that consist of a single fund. Wise investors diversify their portfolios and own multiple funds. Yet, increasing the number of funds drives down the odds of successfully building a portfolio of actively managed funds that would outperform.