Actively managed mutual funds have done worse than is generally thought. Those, at least, are the findings of a study released yesterday covering a ten-year period of performance figures reported by Morningstar, the popular mutual fund tracker.
According to the report by the Zero Alpha Group, a group of eight independent financial planning firms that preach passive investment management, returns as a whole were 1.6 percent lower annually. The reason for the difference is that Morningstar and other trackers like them don’t include the returns of mutual funds that have shut down. This so-called “survivor bias” generally favors the better performing funds and thus, produces an overall gain that’s higher than it would have been if all the losers were included.
The study, “Survivor Bias and Improper Measurement: How the Mutual Fund Industry Inflates Actively Managed Fund Performance,” relied on quarterly data from Morningstar’s Principia mutual fund disks, examining 42 categories over a 10-year period. Funds that were liquidated or merged with others were added back into calculations of performance for each of the categories. Zero Alpha did not calculate overall returns before and after the closed funds were included, but only for the individual categories.
“When the little-understood survivor bias factor is taken into account, actively managed mutual funds in all nine of the of the Morningstar Principia style boxes lagged their related indexes from 1995-2004,” reads the report. “In all but one of the 42 narrower Morningstar fund categories, the survivor bias effect worked to inflate fund returns.”
“One point six percent doesn’t affect investors just a little bit,” says Pat Beaird, co-founder of BHCO Capital Management in Dallas, and a member of the group, “it’s a very significant effect over time.”
Indeed, according to the report certain returns were substantially skewed. For instance, the Mid Blend category returned cumulatively 72 percent less that than Morningstar data would suggest over the ten year period, had the failed funds in that category been included in the calculations.
Don Phillips, a managing director at Morningstar, says he doesn’t dispute the report’s numbers, but says there are many ways to calculate fund performance and pluses and minuses to every one—extracting survivor-bias is only one such way. Says Phillips, “You could also do it by asset-weighting the averages,” which would factor in the size of certain funds. Given the growth and dominance of a handful of fund companies, he adds, this would also be valuable to investors.
Phillips is also quick to dispel any thought of an industry conspiracy. “The fund industry would prefer to have those funds included because it would make their own numbers look that much better,” he says. As to how Morningstar conducts its research, Phillips says it’s simple: “We calculate category averages to help investors pick a fund from the ones that are still alive.” That said, should investors prefer to examine category averages that are survivor-bias free the company began an initiative earlier this year to include such data on its site.
Chandler Taylor, a principal with the Moneta Group, independent financial planning firm in St. Louis with $5.3 billion in assets under management, uses both passive and active strategies for his mostly high net worth clients. And he says the study won’t change that. He says he will often use passive investment strategies for a portion of a client’s large-cap holdings. But he says his mutual fund screens—for low turnover, low fees, manager tenure, consistency and performance—give him actively managed funds with the same benefits of index strategies.
Net of fees, says Taylor, as of December 31st, 2005, 85 percent of the approved funds used by his firm outperformed their 3-year category averages and 92 percent bested the 5-year benchmarks. “If you’re going to do no work on picking the funds, then you should do passive,” he says. “But if you the time and the team, there are premiums to be gained in using active funds, and that’s clearly the case outside of the large cap category.”
