Funds with poor performance and funds suffering from shareholder redemptions are discretely led out of public view. Then they are merged into similar funds that are more successful. Others are simply liquidated.
Most of us don't notice these disappearances because there are a lot of mutual funds out there. It isn't surprising, with a total of more than 10,000 funds, that some funds are never noticed and eventually lost.
But you notice if you're a shareholder.
In August, shareholders in four Aetna funds noticed because Aetna High Yield fund, Index Plus Bond fund, Mid Cap fund, and Real Estate Securities fund were liquidated whether you owned A, B, C, or I shares. During the same month Dreyfus liquidated its Premier Market Neutral and Premier Real Estate funds, Heartland liquidated its Government fund, and Merrill Lynch merged its Utility fund shares into its Global Utility fund. Altogether, 111 funds were either liquidated or merged during the month according to Morningstar.
According to Wiesenberger, a Thomson Financial subsidiary that has been tracking mutual fund performance since the 50's, we are heading for the first year in which more mutual funds will disappear than will be created. Their count shows that 236 new funds were introduced so far this year--- but 176 were liquidated and 419 were merged.
That means the total mutual fund universe has actually decreased by 359 funds. The firm also notes that the fourth quarter is the most active time for liquidating and merging funds. This figure will probably be higher by year-end since there are nearly 4,000 funds that are at least three years old but have less than $50 million in assets under management.
So why am I telling you this? Is this yet another bit of investment trivia? Or does it actually have some implications for you and me?
Mutual fund liquidations and mergers are not a trivial matter because they are part of a dirty little statistical secret.
All the performance figures that are available suffer from what statisticians call "survivor bias." This means that the apparent performance of mutual funds is nudged upwards by the fact that we are always losing the performance of the funds that are liquidated while retaining the performance of the funds that survive.
How big is the survivor bias?
It depends on whose research you use but most puts it at a minimum of 1 percent a year. Accounting and statistics expert Burton Malkiel, for instance, puts the figure at 1.5 percent. If the average fund appears to provide a return of 15 percent, then the average investor has probably experienced a return of 1.5 percent less or 13.5 percent after we include what happened to all the money in the under-performing funds.
Probably the most important message here is that the benefits of index fund investing are, if anything, understated. Managed fund advocates, for instance, are now crowing about how terribly index funds are trailing managed funds. In the 12 months ending September 30th, the average domestic equity fund provided a return of 28.21 percent, trouncing the S&P 500 index by 14.94 percent.
Extend your investment horizon to three years or longer, however, and the average performance of all the surviving funds still trails the index by a substantial amount. Over the last 15 years the average domestic equity fund return 15.44 percent, trailing the S&P 500 index by 2.45 percent a year.
The difference, over that period, means that a $10,000 investment grew to $86,168 under management instead of $118,074 in the index. If the average managed fund return were reduced by the estimated 1.5 percent a year survivorship bias, the average managed fund would have grown even less--- to only $70,818.
The difference, for you and me, is major.
It's also major for the mutual fund industry because they make more money on managed funds than on index funds. The five largest managed funds (Fidelilty Magellan, Investment Company of America, Janus, Washington Mutual Investors, and Fidelity Contrafund) have combined assets of $306.4 billion under management and an average expense ratio of 0.68 percent.
That's a full 0.5 percent more than the major index fund provider and a revenue difference of about $1.5 billion a year. Extend this idea to the average equity fund expense of 1.42 percent a year, and you can see that billions of dollars in investment fees is reinforced by a statistical quirk that is seldom discussed--- survival bias.
This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational puposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.
AssetBuilder Inc. is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and expenses carefully before investing.