Intelligent Design

John McMillen | Portfolio Manager

Learn what matters - and what doesn't - when building a sound investment strategy.

Fund Failures, Survivorship and Your Money

February 2011

Mutual funds have a lifecycle not too different from any living entity: They are born, they grow up, and then, eventually, they die. Unfortunately, many funds perform very poorly and are sent to an early grave, taking much of their shareholders’ original investment with them.

Since the founding of the first mutual fund in 1924, the number of funds in the industry has increased dramatically. According to the Investment Company Institute, the mutual fund industry’s trade association, today there are almost 8,000 mutual funds managing more than $11 trillion dollars:

This huge number of funds, most of which have a team of portfolio managers and analysts scouring the investment landscape for the highest return on their capital, greatly contributes to the efficiency of the market, quickly pushing securities prices to fair value.

The enormous competition also makes it extremely difficult for these funds to add value by finding securities that are mispriced. Managers who build their funds on this strategy often fail, usually after a prolonged period of painfully poor performance. This results in asset redemptions by the fund’s shareholders, ultimately making the fund unprofitable to operate.

The attrition rate for mutual funds is huge. Over the past decade, about 10% of the funds in any given year have either been closed down or merged:

The investment industry preaches about the virtues of a long-term investment view, but a 10% failure rate for mutual funds means the average fund will not last nearly as long as most of their shareholders’ investment horizons!

Though a fund closing can have an obvious negative impact on its shareholders, often it’s viewed as a blessing by the fund company, because it allows them to wipe the slate clean and move forward. You may be surprised to know that, when a fund is liquidated or merged, its substandard performance simply disappears. It’s as if the fund (and the wealth it destroyed) never existed! This allows a company to claim all of their funds have delivered great performance even if many of their funds have been closed or merged due to poor performance. By intent and design, many fund companies can legally distort investors’ perceptions about their fund family’s track record of success.

This also has a profound impact on fund-industry statistics, creating a phenomenon known as survivorship bias. Survivorship bias upwardly skews the number of funds that have beaten a given benchmark because many of the funds that performed the very worst and were closed or merged into more successful funds – historically about 10% of the fund population – are excluded from the data set.

Something to keep in mind the next time you come across those glowing mutual-fund ads in the consumer press!

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