You might not have noticed it, but you\'ve probably never seen an advertisement for a mutual fund that reports a failing return. It\'s an impossibility that every fund could perform so well all the time. But what happens to those inevitable lemons if the mutual fund industry denies any are falling? This is where survivorship bias steps in.

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. This bias is created when poor performing funds are liquidated or merged into better performing funds. As a result, these substandard performers, and their corresponding substandard metrics, simply disappear.

When these so-called "losers" are purged from their respective categories, their statistical records are no longer included in the category performance data. This makes the category averages creep higher than they would have if the losers were still in the mix.

Example - The Survivorship Effect
For example, let\'s say that there are three funds (A, B and C) in a given category. Fund A has a five-year annualized total return of 12%; Funds B and C have five-year annualized total returns of 8% and 4%, respectively. The average annual total return for the fund category would be 8%. But, if the loser, Fund C, were to be liquidated or merged into either Funds A or B, it would disappear from the data radar screen. The five-year average annual total return for the fund category would become a more impressive 10%.

Hedge funds also fall into perils of survivorship bias. Many research and 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.

A "Get out of Jail Free" Card
Fund companies argue they shouldn\'t have to include dead funds in return calculations because the funds are transferred to different managers. But think of it this way: When a person buys a new car he or she doesn\'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 (formerly the Association for Investment Management and Research (AIMR)) has attempted to place restrictions on how past performance is reported. However, this disclosure 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 Financial Industry Regulatory Authority (FINRA) and Securities and Exchange Commission (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. (To learn more about sneaky news in the footnotes, see Footnotes: Early Warning Signs For Investors, An Investor\'s Checklist To Financial Footnotes and Footnotes: Start Reading The Fine Print.)

Don\'t Forget Creation Bias
Creation bias is a form of survivorship bias. A fund company will implement the creation bias 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. The successful funds are then made available to the public and marketed aggressively, while the losing funds get silently discontinued and "disappear". Many investment professionals believe that creation bias is becoming a bigger problem than survivorship bias, particularly because it is much more difficult to detect.

John Bogle, founder and former chairman of the Vanguard Group, often cited the survivor bias phenomenon as one of the reasons for favoring index funds, which don\'t play the survivorship game. Bogle is quoted as saying that "what we are really looking at here are "juiced" managed fund performance numbers, which create a misleading picture that actively managed funds are competitive with indexing."

Survivorship bias is a kind of grade inflation for mutual funds that occurs when the funds with the worst performance are made to disappear from the database while strong performers survive another day. The result of this mutual fund Darwinism results in skewed performance numbers that make the remaining active managers look better as performers vanish before they can drag down the overall performance numbers of the category index.

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. The key, as in so many cases in investing, is to do your research.

Related Articles
  1. Investing

    The ABCs of Bond ETF Distributions

    How do bond exchange traded fund (ETF) distributions work? It’s a question I get a lot. First, let’s explain what we mean by distributions.
  2. Mutual Funds & ETFs

    Passively Managed Vs. Actively Managed Mutual Funds: Which is Better?

    Learn about the differences between actively and passively managed mutual funds, and for which types of investors each management style is best suited.
  3. Mutual Funds & ETFs

    4 Mutual Funds Warren Buffet Would Buy

    Learn about four mutual funds Warren Buffett would invest and recommend to his trustee, and discover detailed analysis of these mutual funds.
  4. Professionals

    How to Navigate Taxable Mutual Fund Distributions

    It's almost time for year-end capital gains distributions for mutual funds. Here's how to monitor them and minimize their tax impact.
  5. Mutual Funds & ETFs

    The 3 Biggest Mutual Fund Companies in the US

    Compare and contrast the rise of America's big three institutional asset managers: BlackRock Funds, The Vanguard Group and State Street Global Advisors.
  6. Mutual Funds & ETFs

    Top 4 Communications Mutual Funds

    Discover some of the best mutual funds in the communications sector, and learn how investors can position investments within these funds.
  7. Investing Basics

    3 Alternative Investments the Ultra-Rich Usually Own

    Learn about the ultra rich and what normally comprises their net worth; understand the top three alternative investments usually owned by the ultra rich.
  8. Mutual Funds & ETFs

    Top 4 Transportation Mutual Funds

    Discover the top-rated mutual funds in the transportation industry, and understand how investors can position these funds in their asset allocation.
  9. Professionals

    5 Top-Rated Funds for Your Retirement Portfolio

    Mutual funds are a good choice for emotional investors. Here are five popular funds to consider.
  10. Mutual Funds & ETFs

    Top 3 Consumer Cyclical Mutual Funds

    Obtain information on, and analysis of, some of the best performing mutual funds that offer exposure to the consumer cyclicals sector.
  1. Can mutual funds only hold stocks?

    There are some types of mutual funds, called stock funds or equity funds, which hold only stocks. However, there are a number ... Read Full Answer >>
  2. How do mutual funds compound interest?

    The magic of compound interest can be summed up as the concept of interest making interest. On the other hand, simple interest ... Read Full Answer >>
  3. Do mutual funds pay interest?

    Some mutual funds pay interest, though it depends on the types of assets held in the funds' portfolios. Specifically, bond ... Read Full Answer >>
  4. Why have mutual funds become so popular?

    Mutual funds have become an incredibly popular option for a wide variety of investors. This is primarily due to the automatic ... Read Full Answer >>
  5. Who do hedge funds lend money to?

    Many traditional lenders and banks are failing to provide loans. In their absence, hedge funds have begun to fill the gap. ... Read Full Answer >>
  6. Do mutual funds pay dividends?

    Depending on the specific assets in its portfolio, a mutual fund may generate income for shareholders in the form of capital ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  2. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  3. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  4. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  5. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  6. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!