LEARN FROM THE LOSERS
October 2017 Market Report

Do you suffer from rearview-mirror syndrome, imagining how a top-performing fund might have boosted your portfolio? If looking at the winners makes you question your investment strategy, you’ll feel better after reading this month’s feature about survivorship bias. Things are not always what they seem. We start with a look at the October numbers.

Global consolidated markets posted a strong October, extending their streak to 12 consecutive months of gains. The Dow Jones Industrial Average rose 4.3% in October, the Nasdaq Composite added 3.61%, and the S&P 500 returned 2.33%, closing out October with its seventh consecutive month of gains. The US performance was above average. Interest rates moved up in September as the Fed hinted at a December interest rate hike. The 10-year US Treasury Bond closed at 2.38%, up from last month’s 2.33%.

World Asset Classes

With broad market indices used as proxies, emerging markets outperformed developed markets, including the US, during the month. The value effect was negative in developed and emerging markets. Small caps slightly outperformed large caps in emerging markets but underperformed in US and non-US developed markets.

US Stocks

The broad US equity market posted positive returns for the month, outperforming non-US developed markets but underperforming emerging markets. Value underperformed growth indices in the US across all size ranges. Large caps in the US outperformed small caps.

International Developed Stocks

In US dollar terms, developed markets underperformed US equity and emerging markets indices during the month. With broad market indices used as proxies, the value effect was negative. Overall, small caps outperformed large caps in non-US developed markets.

Emerging Markets Stocks

In US dollar terms, emerging markets indices outperformed developed market indices, including the US, during the month. With broad market indices used as proxies, the value effect was negative. Overall, small caps slightly outperformed large caps in emerging markets.

Select Country Performance

In US dollar terms, Singapore (5.02) and Japan (4.61) recorded the highest country performance in developed markets, while New Zealand (-6.29) and Finland (-2.40%) posted the lowest. In emerging markets, Korea (8.40), India (7.37), and Taiwan (6.34) posted the highest returns, while Columbia (-8.96) and Pakistan (-7.58) were the lowest.

Select Currency Performance vs. US Dollar

Among developed markets currencies, the New Zealand dollar depreciated by approximately 5%, the Canadian dollar depreciated by 3.25% and the Swiss Franc depreciated by 3%. In emerging markets, the South Korean Wan appreciated by 2.25%, while the Turkish Lira depreciated by about 2.25%.

Real Estate Investment Trusts (REITs)

Non-US real estate investment trusts outperformed US REITs.

Commodities 

The Bloomberg Commodity Total Return Index gained 2.14% during the month. The livestock index led advancing commodities, returning 10.60%. Industrial Metals rallied 5.8%. The energy complex gained 2.5%. The grains were the worst-performing complex, decreasing by -2.50%. Gold prices fell.

Fixed Income

Interest rates increased across the US fixed income market for the month. The yield on the 5-year Treasury note increased by 9 basis points (bps) to 2.01%. The yield on the 10-year Treasury note increased by 5 bps to 2.38%. The 30-year Treasury bond yield increased by 2 bps to finish at 2.88%.

The yield on the 1-year Treasury bill rose 12 bps to 1.43%, and the 2-year Treasury note yield rose 13 bps to 1.60%. The yield on the 3-month Treasury bill increased 9 bps to 1.15%, while the 6-month Treasury bill yield increased 8 bps to 1.28%.

In terms of total returns, high yield bonds gained 0.42%, intermediate-term corporates gained .30%. Municipal bonds generated a total return of 0.24%. 

Impact of Diversification

These portfolios illustrate the performance of different global stock/bond mixes and highlight the benefits of diversification. Mixes with larger allocations to stocks are considered riskier but have higher expected returns over time.¹

FAILED AND FORGOTTEN:
HOW SURVIVORSHIP BIAS AFFECTS OUR CHOICES

Survivorship bias is a counterintuitive way of evaluating information. The definition is right there in the name. The “bias” colors our thinking when we make assumptions based on survivors, without accounting for the large number of non-survivors that once populated the same space. Learning to spot this bias can make us smarter financial consumers and far more skeptical of marketing claims. Once you grasp the idea, it can make you question everything.

Most survivorship bias stems from incomplete or hidden data. It’s obvious that if we look at only a small subset of a larger sample, our conclusions will be misleading or just plain wrong. In the investment world, consumers make decisions based on narrow subsets all the time. Our evaluations don’t include data from the graveyard of failed mutual funds, REITS, alternative strategies, banks, independent advisors or the Bear Stearns of the world. Instead, most investors base decisions on the few, rare, temporary winners.

One of the most noteworthy examples of survivorship bias is from World War II. This is a real life-or-death tale in which mathematical thinking and awareness of bias saved the day. The issue was urgent: Why were so many Allied aircraft being shot down? Military officers knew that additional armor was needed to protect their aircraft. But where should it be strategically placed to do the greatest good? The best military minds thought the answer was to armor planes where they had sustained the greatest damage.

The abstract mathematician Abraham Wald saw things differently. It was clear to him that the officers’ ideas were based on a subset of planes, limited to those that returned after battle. If those returning planes were being hit randomly, as the mathematicians reasoned, they offered evidence of where planes could take hits and survive. In How Not to be Wrong (Penguin Press, 2015), author Jordan Ellenberg writes that Wald concluded the armor “doesn’t go where the bullet holes are. It goes where the bullet holes aren’t: on the engines. Wald’s insight was simply to ask, where are the missing holes?”

That’s survivorship bias in a nutshell. Ellenberg, himself a mathematician, points out that “It arises again and again in all kinds of contexts. And once you’re familiar with it, as Wald was, you’re primed to notice it wherever it’s hiding.”

Let’s look at survivorship bias in the context of mutual fund investing.

Scorecard, Please

Mutual fund scorecards, including well-known Morningstar ratings, are an excellent example of survivorship bias and how it leads to highly misleading conclusions. These scorecards purportedly rank the winners and losers over 3, 5, 10 and 15-year investment horizons. But only funds that survived the full period of evaluation are included in Morningstar ratings; funds that disappeared, were merged or liquidated are not. When large subsets of negative data are ignored, the results are skewed upwards. So investors should be cautious in interpreting performance statistics computed with survivorship bias.

For a sober and realistic assessment, investors should consider the S&P Dow Jones Indices Versus Active (SPIVA) scorecards, which include all funds that started each evaluated period. According to the 2017 mid-year SPIVA report, more than 58% of domestic equity funds, 55% of international equity funds, and approximately 47% of all fixed income funds were merged or liquidated over the previous 15 years. While investors may find the size of the non-surviving funds surprising, these findings underscore the importance of accounting for survivorship bias in mutual fund studies.

The Case of the Disappearing Funds

A Vanguard study of disappearing and so-called dead funds over 15 years (1997 through 2011) reached a similar conclusion. Of 5,108 funds, just 54% survived the full 15 years. The 2,364 funds that didn’t survive were either liquidated or merged, mostly due to poor performance.

Let’s look at large caps specifically. Investing in the 34% of surviving large cap funds that outperformed their benchmarks over 15 years may have felt wise until fund closures were taken into account, which dropped the percentage of outperformers from 34% to just 18%. Across all funds, the chance of picking an underperformer was 79%.

What Happened to Merged or Liquidated Funds?

When things aren’t going well, a merger can be a lifesaver. Or not. Of stock funds that merged with others over 15 years of the Vanguard study, 87% were underperformers prior to the merger, and 73% continued to underperform after the merger.

Adding Insult to Injury: Closed & Liquidated Funds

To recap the Vanguard study, 54% of funds survived the 15-year period and 37% merged. That leaves an especially unlucky 9% of funds that were liquidated, taking investors down with the ship. These funds were the dogs of the Vanguard study (no insult to dogs), underperforming the median merged fund by -1.11% (we’ve already noted how dismal the merged fund record was).

Ugly, but it gets worse. According to Vanguard, at this point “The best possible outcome for investors is that they are forced to sell at a time not of their choosing. A worst-case scenario, on the other hand, could mean not only that investors suffer through significant underperformance, but also that embedded gains result in a taxable distribution and … the sale occurs at a premium to the investors’ cost basis, [resulting in] two layers of taxes.”

Consider that the bruised and battered investor now faces the daunting task of choosing a new fund. Good luck with that. The 2017 mid-year SPIVA study shows that over 93% of large-cap managers, and over 94% of mid-cap and small-cap managers, failed to beat their benchmarks over 15 years. Those that survived and outperformed or were merged and outperformed was less that than what would be expected by random chance. This adds to a large body of evidence from Fama and French and others that beating the markets is a matter of luck and not skill.

What about other investment categories covered in the SPIVA study? The majority of global, international and emerging market equity managers underperformed their respective benchmarks for the 15 years. As for fixed income managers, the results were just as disappointing.

Don’t Bet on Winner’s Luck
As the year draws to a close, it’s guaranteed that some fund or other will break away from the pack. You’ll see some dazzling results, reinforced by a flurry of 2018 investment recommendations from the financial media.

Improbable events do happen. So, no one should be taken aback if and when they occur. For example, it’s highly unlikely anyone can pick fund winners in advance. But what we can say with certainty is that the risk of picking losers is high. And bad guesses can spell the difference between a worry-free retirement and a much less desirable outcome.

Put on your survivorship-bias cap and think about it. We have no idea how many failed attempts it takes to produce one high-performing fund. The failure rate is generally hidden. And the fund winners of today will fall off the charts tomorrow. Once you understand these fundamental truths, Morningstar ratings will have no power over you.

Better to stick with a proven low-cost strategy, diversified portfolio and independent advisor. Better to armor your plane in the right places as a new year begins.

1. Diversification does not eliminate the risk of market loss. Past performance is not a guarantee of future results. Indices are not available for direct investment. Index performance does not reflect expenses associated with the management of an actual portfolio. Asset allocations and the hypothetical index portfolio returns are for illustrative purposes only and do not represent actual performance. Global Stocks represented by MSCI All Country World Index (gross div.) and Treasury Bills represented by US One-Month Treasury Bills. Globally diversified allocations rebalanced monthly, no withdrawals. Data © MSCI 2017, all rights reserved. Treasury bills © Stocks, Bonds, Bills, and Inflation Yearbook™, Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield).