I was reading an article that mentioned 'survivorship bias' in regards to mutual funds. What is the average timeframe given before a fund is considered to be poorly performing?
Hi Bennett, Survivorship bias refers to mutual fund companies "retiring some of their funds which are low in assets and or poorly performing. The fund may have been hot ten years ago for several years and the can roll this fund into a better performing one. This boosts the historical return in the latter fund. As far as the average time frame before a mutual fund family decides to do this, I honestly don't know. If you invest in index and Exchange Traded Funds this is less likely to happen.
Bennett - Survivorship bias is not limited to mutual funds or even finance, but it can be a significant problem in analyzing mutual fund returns. When one looks back in time at a collection of statistical data to try to determine "what worked in the past," the data sets generally exclude assets that went to zero (or in the case of stocks, companies that were merged or acquired) and were therefore eliminated from the sample. The only assets in the set today are the ones that "survived" over time, hence the term. If the assets that did not survive are included in such analysis, the effect can be quite significant, depending on the other biases at play and the frequency and nature of changes.
Survivorship bias can be especially problematic with mutual fund performance because of the tendency of some investment firms to systematically launch new funds and shutter poor-performing funds. Serious analysts use point-in-time data to eliminate survivorship and other common statistical biases that impact investment return data.
On your other question --- how long does it take to know that a fund is performing poorly... It could be a very short time--- as short as a few months if the fund is especially awful. The more difficult question to answer is how long it takes before one knows that a fund is especially good. From a statistical standpoint, it could take years to establish this fact with a high degree of confidence. There are factors other than performance, such as style analysis, tracking error, risk factor analysis, and numerous qualitative factors that professional advisors use to identify and select funds. The difficulty of demonstrating the value added by active managers is one of the most compelling arguments for relying on passive investment strategies for asset allocations to common risk types, such as equities and fixed income, and investing in funds with very low fees and expenses.
Hi Bennett, I would make a couple of points: first, survivorship bias isn't particularly relevant when evaluating past performance of a single fund, because that fund either exists or it doesn't, there's nothing hidden about its performance. I'm not wading into the active index debate here, but you cannot conclude that the existence of survivorship bias favors index fund investing. That argument needs to be made on other merits. Survivorship bias is relevant to evaluating performance by a group of funds from a fund family, a fund manager, or an investment strategy; you would want to know whether published returns included folded or merged funds.
Also, the concept of survivorship bias is especially salient with financial products that tend to have a high rate of failure. Hedge funds are a prime example where historical returns look a lot better when only surviving funds are analyzed. The billions lost in Madoff's fund and Long-Term Capital Management don't show up in anyone's performance today, but remain a blight on the industry, in my opinion.