Friday, September 28, 2007

How funds companies will sell you a lemon and tell you its lemonade

I'd heard of the concept of survivorship bias before, but I've been living the dream for myself this week.

When mutual funds companies boast about their cumulative returns over the years, its often a little bit misleading, critics say, because the money-losing funds they churned out over the years get killed off or blended into new products, so their gaudy failure rates don't get factored into the numbers. In a nutshell, that's what's known as survivorship bias.

To give an extreme example, if you buy a mutual fund that loses 90% of its value in the first year, that's going to be one ugly black mark on that company's performance ratio for years to come. They'd need several years worth of double-digit returns in subsequent years just to get back to break-even.

But, if they take that fund and roll it into a new product after that ugly first year, then all of a sudden they can pretend the one horrific year never happened, and instead trumpet the steady gains they've made for you on the new product. The black mark disappears, replaced by a shiny, new money-making product for you. Ignoring the fact, of course, that at the end of the day, you haven't actually made any money. It's just been sliced and diced around between several products, distracting you from the key issue.

That's exactly what happened to my lone mutual fund this week. That ugly -86% return since inception? Never happened, apparently. But boy, doesn't that 5% return on my shiny new fund sound impressive? Look at all that black ink! And look, the fund's chart actually points up!

Warrants mentioning.


mariam said...

One of my first purchased mutual funds just did that. It's a stinker as well. I was in the 6th year of a 7 year mutual fund backend jail sentence, thinking of riding it out. I wonder if this new roll over will make me start over :P Time to make a phone call...

nancy (aka money coach) said...

thanks for the heads up!
and I had a Classic experience this week - stuck (various reasons) with a financial planner/mutual funds who proudly pointed out in our 1st annual review (last week) that the portfolio was up 10%. Yet when I insisted on taking a calculator, adding up my contributions for the year, my portfolio's market value was in fact LESS than the totals of my contributions. 10%? Not for me. F. Planner genuinely at a loss on how to explain it. Unbelievable. Most of my money is self-directed but I don't have options on this one chunk of of money. Driving me nuts.