The high mortality rate of mutual funds hurts investors

David Peartree, The Daily Record Newswire

The Book of Ecclesiastes reminds us that all things eventually turn to dust, but investors might wonder why so many mutual funds are in such a hurry. Mutual funds have a surprisingly high mortality rate and over time that exacts a toll on investors’ returns.

Funds die when they are merged into other funds or they are shut down and liquidated. In either case, the primary reason for fund closures is underperformance. Funds that are merged or liquidated usually have underperformed their market benchmark and their peer group in the years leading up to closure.

When an underperforming fund is shut down and liquidated the sale of the fund’s underlying holdings may trigger taxable gains. It’s as if the investor had sold the fund.

More often, underperforming funds are simply merged with another fund. Merger suggests a more benign outcome for investors, but the data says otherwise. Mergers do not generally result in better performance than with the original fund. The overwhelming number of merged funds underperformed before merger and underperformed after merger.

From an investor’s perspective, whether a fund is liquidated or merged with another fund, the effect is much the same. It means investment returns have suffered. In addition to the years of underperformance leading up to closure, the fund will likely incur higher transaction costs during the liquidation or merger. And if the account is not tax sheltered, liquidation may trigger taxable gains and an unwelcomed tax liability.

How pervasive is the problem? One study looked at funds over a 17-year period and found that less than 40 percent of the funds in operation in 1995 were still around by the end of 2012. More than 60 percent of the funds were either liquidated or merged into existing funds.

Another study covered a 15-year period from 1997 through 2011. Only 54 percent of the original funds were still around at the end of 15 years. The other 46 percent were merged or liquidated. That’s a lot of carnage.

Morningstar ratings provide some interesting insights on the issue of survivability. Star ratings are useful for identifying those funds most likely to fail. Five star funds, the highest rated, are the least likely to fail; one and two star funds were the most likely to fail.

But don’t get your hopes up. Survivability is not the same as success. Ratings may be helpful for avoiding the losers but not necessarily for picking the winners. Morningstar ratings are not helpful for predicting which funds will outperform their market benchmark. Moreover, even among five star funds just over 20 percent, about one in five, went out of business over a 10-year period.
What are the implications for investors?

First, the high mortality rate among mutual funds confirms what we know from other studies. Too many investors are underserved by the investments they own. Most funds underperform their relevant market benchmark. A large number of funds go out of business due to underperformance, and even among the survivors many continue to deliver sub-par performance.

Second, the high mortality rate among mutual funds highlights the challenge of assembling a successful portfolio. Assembling a portfolio of market-beating funds, or even market-matching funds, is a low probability venture. The risk is that unless the investor chooses well, adding more funds to a portfolio may drive down the odds of success.

Third, when considering reports on mutual fund performance, investors need to consider the impact of survivorship bias. Survivorship bias refers to the overstatement of investment performance by failing to account for all the funds that have ceased to exist. Here is an example cited by Larry Swedroe, an investment researcher and author.

A Lipper study found that the 568 stock funds existing in 1986 reported an average investment return of 13.4 percent. Ten years later, in 1996, the figure reported for the 1986 performance had increased to 14.7 percent. What explained the 1.3 percent improvement in the performance for 1986?

By 1996 all of the funds that had underperformed and had gone out of business were dropped from the database. The revised figure published in 1996 for the 1986 performance excluded all the funds that no longer existed, thereby making the collective performance of the surviving mutual funds look better. Investors should question any performance data that does not properly eliminate survivorship bias.
The high mortality rate among mutual funds should have investors questioning the conventional approach to assembling a mish-mash of mutual funds and hoping for the best.

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David Peartree, JD, CFP® is the principal of Worth Considering Inc., a registered investment advisor offering fee-only investment and financial advice. Offices are located at 160 Linden Oaks, Rochester, N.Y. 14625, david@worthconsidering.com.
 

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