Mutual Fund Scam: “Survivorship Bias” and Masking Luck as Skill

Investors wanting to diversify their portfolios often turn to equity mutual funds to get exposure to a variety of companies and industry sectors. The $15-trillion mutual fund industry in the United States was built on this desire for diversification, and mutual fund companies devote massive resources in their sales and marketing efforts.

Unfortunately for investors, one widespread marketing pitch employed by mutual fund companies is deceptive. When a company claims that its funds have “consistently outperformed the S&P 500,” investors should be skeptical.

In his incisive, humorous, plain-English book exploring how statistics can be used and abused, “Naked Statistics: Stripping the Dread from Data,” author and professor Charles Wheelan explains how it works.

The mutual fund industry has aggressively (and assiduously) seized on survivorship bias to make its returns look better to investors than they really are. Mutual funds typically gauge their performance against a key benchmark for stocks, the Standard & Poors 500, which is an index of 500 leading public companies in America. If the S&P 500 is up 5.3 percent for the year, a mutual fund is said to beta the index if it performed better than that, or trail the index if it does worse. One cheap and easy option for investors who don’t want to pay a mutual fund manager is to buy an S&P 500 Index Fund, which is a mutual fund that simply buys shares in all 500 stocks in the index. Mutual fund managers like to believe that they are savvy investors, capable of using their knowledge to pick stocks that will perform better than a simple index fund. In fact, it turns out to be relatively hard to beat the S&P 500 for any consistent stretch of time…. Of course, it doesn’t look very good to lose to a mindless index that simply buys 500 stocks and holds them. No analysis. No fancy macro forecasting. And much to the delight of investors, no high management fees.

What is a traditional mutual fund company to do? Bogus data to the rescue! Here is how they can “beat the market” without beating the market. A large mutual fund company will open many new actively managed funds…. For the sake of example, let’s assume that a mutual fund company opens twenty new funds, each of which has a roughly 50 percent chance of beating the S&P 500 in a given year…. Now, basic probability suggests that only ten of the firms’ new funds will beat the S&P 500 the first year; five funds will be it two years in a row; and two or three will be it three years in a row.

Here comes the clever part. At that point, the new mutual funds with unimpressive returns relative to the S&P 500 are quietly closed…. The company can them heavily advertise the two or three new funds that have “consistently outperformed the S&P 500”—even if that performance is the stock-picking equivalent of flipping three heads in a row. The subsequent performance of these funds is likely to revert to the mean, albeit after investors have piled in. The number of mutual funds or investment gurus who have consistently beaten the S&P 500 over a long period is shockingly small.

The whole book is fascinating and well worth your time, and this section helps us understand how important it is to be on guard against impressive-sounding claims made by financial advisors, mutual fund companies and others who stand to profit from convincing you that they are the proverbial “smartest guys in the room.”

If you have suffered an investment loss as a result of your broker pitching an investment without disclosing its risks or explaining less expensive alternatives to achieve the same objectives, please contact a securities attorney at The Galbraith Law Firm at 212.203.1249 or kevin@galbraithlawfirm.com for a free confidential consultation regarding your legal rights.