A blog I read on relatively daily basis is that of the Canadian Capitalist (link in the sidebar). The main reason is that his ideas, temperament, strategies and goals are somewhat similar to mine. The second reason is that by being one of the most frequented Canadian finance blogs, he brings in an informed readership that offers a wealth of information, opinions and dialogue.
One of the comments on his March 1st post had a link to an interesting report from S&P that discusses index vs. actively managed funds and their returns. There are several aspects of this report that interest me, but the thing that stands out the most is the commentary/data on survivorship bias correction.
A slight digression: Advocates of actively managed mutual funds (or the pamphlets of the companies that sell them) often quote data that suggests that those funds are better than index investing.
The truth is that this data often does not include information regarding funds that have ceased to be.
I first became aware of this when I read The Intelligent Investor by Benjamin Graham with commentary by Jason Zweig back in 2007. Zweig shows data in the commentary to chapter 9 (p. 248) regarding how many funds outperform the index, and in the footnotes, points out that the data does not account for all the funds that are no longer in existence.
The S&P report, however, takes this into consideration and reports the numbers as they are. In other words, the percentage that the S&P report presents gives the percentage of the funds that existed at the end of 2009, with the base being all the funds that existed a certain number of years ago.
An an example using data from the report: there were 153 U.S. equity funds 5 years ago. At the end of 2009 there were only 73 (in other words, 80 funds have disappeared, either because they failed so miserably and have liquidated… fund lingo for “folded”… or because they merged into other funds). Of the remaining 73 that were still in existence, only 14 had outperformed the U.S. index over the 5 year period.
A fund company may state the following: 20% of managed funds out-perform the index over 5 years (because 14 out of 73 is 20%)
This is like saying 50% of baseball teams win the World Series because there are 2 teams in the series, and 1 wins.
In reality however, only 9% of the funds managed the feat of out-performing the index because an investor 5 years ago had the option of 153 funds… not 73. Put another way, and investor 5 years ago who put his/her money into an actively managed U.S. Equity fund had a 91% chance of underperforming the index.
And this is the value of the S&P report on Canadian funds, as it takes this into consideration, and reports the numbers as they should be reported.
Back to the baseball example for a moment, there were many teams that did not make the play-offs, and others that were eliminated in the round-robin. In any given year, only 1 team out of 30 can win the World Series. [the odds increase to 1 out of 29 if you accept that Toronto is a non-factor 😉 ]
Any bookie understands this. The odds they give on any given team to win the World Series on day one of the season will vary greatly from the odds they give the same team when they are up 3 games to nil on the eve of game four.
Remember that when you pick your next fund.