RandomGuy
08-15-2006, 10:35 AM
As an accountant, I get a lot of questions from people I meet about investing and money. I enjoy very much sharing the knowledge of this topic that I have gained over the course of my education (I am almost finished with a masters in accounting).
There is always a lot of interest in the topic and it is something that both ends of the spectrum here can probably talk about without too much acrimony, so I will start this thread, and maybe some good will come out of it.
Disclaimer:
I am NOT a certified financial advisor. Oddly enough, neither are most people who call themselves financial advisors, although that is changing for the better.
I AM very literate in finance and tax laws. I am NOT a CPA, but will be by next summer, if I can fit it into my schedule. I have 90% of the education required to sit for the exam at this point, though. Part of my real-life job involves analysing investment portfolios for insurance companies that routinely have tens of millions of dolllars to tens of billions of dollars in invested assets, so I DO have a bit more knowledge of the mechanics of investing (especially bonds) than an average accountant.
The purpose of this thread is in the spirit of education, much like the motley fools (http://www.fool.com) (see linked website) who offer free education on financial topics.
For the mods:
Pardon the mixing of financial education and sports. Heh.
On that note, here is a good article from the investopia folks.
Have you ever seen an advertisement for a mutual fund that reports a terrible return? We've never seen it! Yet it seems impossible for no fund to perform poorly. So what happens to the lemons if the mutual fund industry claims that all its funds are winning?
It doesn't take a rocket scientist to realize that the public doesn't invest into funds that historically perform poorly, so, to keep its customers, the mutual fund industry has a trick up its sleeve when it comes to bad funds. Many fund companies simply fold their bad funds into better performing funds. This means that reports of the funds' performance have been skewed by survivorship bias, which can make you think a fund company beats the market when really it underperforms.
Welcome to the Biased World of Survivorship
A mutual fund company puts survivorship bias into action when distorting the true performance of its mutual funds, making the funds look more attractive than they really are. Survivorship bias occurs when funds with poor performance have been wiped out or made to disappear while strong performers continue to exist, creating skewed statistical data: survivorship bias makes it appear as though the poor performers never existed at all. A mutual fund company's current selection of funds will only include those funds that have been successful in the past. In other words, to hide any poor performance, the funds that exhibited bad returns would have been closed and/or merged into other funds.
For example, right after the dotcom crash many high-flying Internet funds had sunk to the point at which they weren't worth managing. Often companies simply merged their Internet fund into a larger "technology" fund. Not only did the sector funds get watered down, but the past losses were wiped from history as the new funds just treated the merger as an influx of cash. (Read more on the dotcom crash here.) In short, survivorship bias creates an over-estimation of past returns and misleads investors into being over-optimistic of high future returns.
The Journal of Finance (Mar 1997) reports a comprehensive study by Mark Carhart on mutual funds over the period from 1962 to 1993. He states that "by 1993 fully one-third of all mutual funds had disappeared." Furthermore, in 1997 the Wall Street Journal reported that during 1982-1992 mutual funds reported average returns of 18.1%, but after calculating in survivorship bias, the report found that this return was whittled down to 16.3%, lower than the 17.5% return on the S&P 500 during the same period. In other words, when we take survivorship bias into account, the average mutual fund underperforms the market.
Hedge funds also fall into perils of survivorship bias. Many research & database firms, however, didn't start collecting data on retired hedge funds until 1994, so research on this area has yet to come to a definite conclusion. Just be careful when looking at any hedge fund returns reported before 1994 because there is a good chance survivorship bias skews the numbers significantly.
Should Mutual Fund Companies Have This "Get out of Jail Free Card"?
Fund companies argue that they shouldn't have to include dead funds in return calculations because the fund is transferred to a different manager. When a person buys a new car he or she don't get to erase all accidents and speeding tickets, so why is it that mutual fund companies virtually get to erase their past mistakes?
The CFA Institute (fomerly the Association for Investment Management and Research (AIMR)) has attempted to place restrictions on how past performance is reported. (For more on this, see "AIMR Performance Presentation StandardsOverview.") This disclosure, though, isn't a requirement for mutual fund companies. They follow the restrictions only if they choose. Even companies that do comply usually only need to publish their true performance in the fine print on the prospectus or other promotional material that most investors don't read. The NASD and SEC have also made decisions on how funds report their returns, but there is still a gray area that can be (and often is) exploited by many companies.
Don't Forget Creation Bias
Creation bias is a form of survivorship bias a fund company implements to launch a fund. Creation bias works by giving a handful of investment managers a small amount of money to incubate their own funds. After a couple years, the fund company chooses the manager who has performed the best because the better the performance, the more attractive the marketing pamphlets look. The successful funds are then made available to the public and marketed aggressively while the losers disappear as they are silently discontinued. Many investment professionals believe that creation bias is becoming a bigger problem than survivorship bias, particularly because it is much more difficult to detect.
Conclusion
Perhaps John Bogle (founder of Vanguard) had it right when he started advocating the idea that index funds are the only mutual fund investors should buy. When you take into account the super-low management fees, this argument for index funds becomes even stronger.
The issues of survivorship and creation bias demonstrate the importance of being skeptical of mutual fund performance claims, particularly when the claims are coming from the company itself. Like we say so often, the key is to do your research. Before buying, always dig a little deeper into the prospectus to see what the true returns of a fund have been.
By Investopedia Staff, (Investopedia.com)
http://www.investopedia.com/articles/02/013002.asp
There is always a lot of interest in the topic and it is something that both ends of the spectrum here can probably talk about without too much acrimony, so I will start this thread, and maybe some good will come out of it.
Disclaimer:
I am NOT a certified financial advisor. Oddly enough, neither are most people who call themselves financial advisors, although that is changing for the better.
I AM very literate in finance and tax laws. I am NOT a CPA, but will be by next summer, if I can fit it into my schedule. I have 90% of the education required to sit for the exam at this point, though. Part of my real-life job involves analysing investment portfolios for insurance companies that routinely have tens of millions of dolllars to tens of billions of dollars in invested assets, so I DO have a bit more knowledge of the mechanics of investing (especially bonds) than an average accountant.
The purpose of this thread is in the spirit of education, much like the motley fools (http://www.fool.com) (see linked website) who offer free education on financial topics.
For the mods:
Pardon the mixing of financial education and sports. Heh.
On that note, here is a good article from the investopia folks.
Have you ever seen an advertisement for a mutual fund that reports a terrible return? We've never seen it! Yet it seems impossible for no fund to perform poorly. So what happens to the lemons if the mutual fund industry claims that all its funds are winning?
It doesn't take a rocket scientist to realize that the public doesn't invest into funds that historically perform poorly, so, to keep its customers, the mutual fund industry has a trick up its sleeve when it comes to bad funds. Many fund companies simply fold their bad funds into better performing funds. This means that reports of the funds' performance have been skewed by survivorship bias, which can make you think a fund company beats the market when really it underperforms.
Welcome to the Biased World of Survivorship
A mutual fund company puts survivorship bias into action when distorting the true performance of its mutual funds, making the funds look more attractive than they really are. Survivorship bias occurs when funds with poor performance have been wiped out or made to disappear while strong performers continue to exist, creating skewed statistical data: survivorship bias makes it appear as though the poor performers never existed at all. A mutual fund company's current selection of funds will only include those funds that have been successful in the past. In other words, to hide any poor performance, the funds that exhibited bad returns would have been closed and/or merged into other funds.
For example, right after the dotcom crash many high-flying Internet funds had sunk to the point at which they weren't worth managing. Often companies simply merged their Internet fund into a larger "technology" fund. Not only did the sector funds get watered down, but the past losses were wiped from history as the new funds just treated the merger as an influx of cash. (Read more on the dotcom crash here.) In short, survivorship bias creates an over-estimation of past returns and misleads investors into being over-optimistic of high future returns.
The Journal of Finance (Mar 1997) reports a comprehensive study by Mark Carhart on mutual funds over the period from 1962 to 1993. He states that "by 1993 fully one-third of all mutual funds had disappeared." Furthermore, in 1997 the Wall Street Journal reported that during 1982-1992 mutual funds reported average returns of 18.1%, but after calculating in survivorship bias, the report found that this return was whittled down to 16.3%, lower than the 17.5% return on the S&P 500 during the same period. In other words, when we take survivorship bias into account, the average mutual fund underperforms the market.
Hedge funds also fall into perils of survivorship bias. Many research & database firms, however, didn't start collecting data on retired hedge funds until 1994, so research on this area has yet to come to a definite conclusion. Just be careful when looking at any hedge fund returns reported before 1994 because there is a good chance survivorship bias skews the numbers significantly.
Should Mutual Fund Companies Have This "Get out of Jail Free Card"?
Fund companies argue that they shouldn't have to include dead funds in return calculations because the fund is transferred to a different manager. When a person buys a new car he or she don't get to erase all accidents and speeding tickets, so why is it that mutual fund companies virtually get to erase their past mistakes?
The CFA Institute (fomerly the Association for Investment Management and Research (AIMR)) has attempted to place restrictions on how past performance is reported. (For more on this, see "AIMR Performance Presentation StandardsOverview.") This disclosure, though, isn't a requirement for mutual fund companies. They follow the restrictions only if they choose. Even companies that do comply usually only need to publish their true performance in the fine print on the prospectus or other promotional material that most investors don't read. The NASD and SEC have also made decisions on how funds report their returns, but there is still a gray area that can be (and often is) exploited by many companies.
Don't Forget Creation Bias
Creation bias is a form of survivorship bias a fund company implements to launch a fund. Creation bias works by giving a handful of investment managers a small amount of money to incubate their own funds. After a couple years, the fund company chooses the manager who has performed the best because the better the performance, the more attractive the marketing pamphlets look. The successful funds are then made available to the public and marketed aggressively while the losers disappear as they are silently discontinued. Many investment professionals believe that creation bias is becoming a bigger problem than survivorship bias, particularly because it is much more difficult to detect.
Conclusion
Perhaps John Bogle (founder of Vanguard) had it right when he started advocating the idea that index funds are the only mutual fund investors should buy. When you take into account the super-low management fees, this argument for index funds becomes even stronger.
The issues of survivorship and creation bias demonstrate the importance of being skeptical of mutual fund performance claims, particularly when the claims are coming from the company itself. Like we say so often, the key is to do your research. Before buying, always dig a little deeper into the prospectus to see what the true returns of a fund have been.
By Investopedia Staff, (Investopedia.com)
http://www.investopedia.com/articles/02/013002.asp