Morningstar says it's far from hidden, the effect is anyway debatable. Mutual-fund investors beware. So says a study by advisory-firm network Zero Alpha Group (ZAG). The report warns that a “survivor bias” in Morningstar's mutual-fund database overstates the performance of actively managed funds and lead investors to chose actively managed funds over indexed funds.

The study, which measured Morningstar Principia Mutual Fund data for the period between 1 January 1995 and year end 2004, defines survivor bias as “a kind of grade inflation for mutual funds that occurs when the funds with the worst performance are made to disappear from the database while strong performers move forward.” As a result, ZAG says the performance numbers are skewed because weak performers are booted out of the category before they can a negative impact on overall performance.

Actually it’s less that they’re actively removed than that poor performers tend to get liquidated or merged out of existence.

Way off

Whatever the mechanism for removing poor performers, ZAG says the Morningstar “Mid Blend” category in fact returned 72% less than Morningstar data would suggest for the study period. The largest evidence of survivor bias exists in the “Aggressive Growth Fund” category, which has a 116% cumulative return difference. The “Corporate High Quality Fund” category demonstrated the least survivor bias with a 0.4% return disparity.

Brent Brodeski, co-author of the study and a managing director of Rockford, Ill.-based Savant Capital, a ZAG member, says that survivor bias had the effect of inflating fund returns in all but one of the 42 Morningstar fund categories. “Very few investors know about survivor bias, but it should be a major concern,” he says. “What we are really looking at here are ‘juiced’ mutual-fund-performance numbers [that create the] misleading picture that actively managed mutual funds are somewhat competitive with indexing.”

Morningstar says ZAG’s warning about survivor bias in its fund-performance data has merit. Far from ignoring it, however, the Chicago-based database publisher has been working to mitigate the problem.

“Although the [ZAG] study asserts that Morningstar has had blinders on about the issue of survivorship bias, we’ve discussed the issue openly,” Morningstar analyst Christine Benz writes in a 30 March 2006 rebuttal to the ZAG report. “In addition, we’re in the process of developing a survivorship-bias-free database, and frequently turn to it when running studies on funds’ past performance.”

Not quite

And Benz has little time for ZAG’s argument that survivor bias has led investors to choose active managers over indexed funds. “There’s absolutely no evidence that survivorship bias has prompted investors to shy away from index funds, as the study’s authors assert,” she writes. In fact, she adds, the evidence points the other way. “The Vanguard Group, whose domestic-equity lineup is anchored by index funds, remains the largest fund shop in the country, and three of the 12 largest mutual funds are Vanguard index offerings.”

In addition, Benz points to recently published data from the Financial Research Corporation , a Boston-based consultancy, showing that six of the 10 biggest asset gatherers for the year to date were either exchange-traded funds (ETFs) or traditional indexed mutual funds. “By far the fastest-growing pocket of the fund industry for the past several years has been in [ETFs],” she adds.

Still, Savant portfolio manager and study co-author Amy Barrett, says the new research puts paid to active managers claims that “anomalies” point to inefficiencies in certain market segments. “This study demonstrates that when properly measured – using proper benchmarks, adjusting for survivor bias, and looking at time periods that span complete market cycles – nearly all the presumed “anomalies” that supposedly favor active managers disappear.”

ZAG’s advice to investors: pursue low-cost investment strategies and to be more wary of actively managed funds.

ZAG is a network of nine independent investment-advisory firms that manage nearly $6 billion in assets. Members of the group are committed to providing objective, long-term private wealth management solutions to investors, focusing on asset allocation and a structured, quantitative approach to investing. –FWR

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