What to Know About Track Records
The track records of mutual funds, as well as hedge funds, are often not what they seem to be. Performance results are commonly presented with significant flaws and/or are not evaluated properly by investors.
Performance Should Be Evaluated Over a Full Market Cycle
Many strategies outperform during bull markets. If a fund has bet aggressively or uses leverage, it will show great returns, but it is what happens during the subsequent bear market that counts. Chances are the aggressive investment strategy that outperformed during the bull market will become an aggressive loser during the next bear market.
Many portfolio managers with strong trailing three- and five-year performances in 2000 and 2007 saw their records (and, more importantly, their clients’ capital) decimated by the bear markets that followed. Other portfolio managers may have successfully protected principal during the downturns, yet failed to re-enter the markets aggressively, leaving their clients with a sub-par return.
A complete market cycle contains both a bull and a bear market. It is critical to view active managers and investment strategies through the lens of a complete cycle so you can evaluate how the investment strategy opportunistically positions itself to earn extra returns or minimize losses in both bull and bear environments. Investors too often chase performance by looking at recent three- to five- year return track records, only to be disappointed with the real results that are delivered in subsequent years when the market regime shifts.
Our methodology evaluates our strategies over four full market cycles.
Risk, Not Just Return, Needs to Be Evaluated
It has been shown conclusively that investors, as demonstrated by mutual fund inflows and outflows, strongly chase the latest raw return performance numbers and they do so without regard to risk (1). This is true for retail investors and, to a lesser degree, institutional investors.
(1) Sources: “Do Investors Care about Risk? Evidence from Mutual Fund Flows,” Christopher P. Clifford, etal., January 2011
“Chasing Returns Has a High Cost for Investors,” YiLi Chien, stlouisfed.org, April 14, 2014
Investors are only looking at half “the picture” when they make decisions based on returns only -- they also should be evaluating risk measures and risk-adjusted returns (Alpha). That means looking at the Sharpe Ratio, Sortino Ratio, Maximum Drawdown Percentage, and/or Alpha to access the level of risk associated with the strategy. Morningstar provides this data for mutual funds, as well as hedge funds and we provide it for all of our strategies. To properly evaluate a strategy requires examining the track record for risk as well as return.
Survivorship Bias: Is That Track Record Real?
Survivorship bias describes one of the most common – and momentous – flaws in data analysis. Largely ignored by the industry in the past, it can lead to significant distortions in the presentation of performance figures which in turn can lead to erroneous investment decisions. Specifically it has been blamed for overstating active funds’ performance.
Survivorship bias occurs when funds with poor performance are wiped out or made to disappear from the databases of performance tracking companies as the result of fund mergers or outright fund liquidations while strong performers continue to exist creating a skewed statistical database. Survivorship bias makes it appear as though the poor performers never existed at all.
Why is this a problem? When you look at Morningstar’s mutual fund performance data by category or style, the returns are overstated because they discard the poorest performing funds. The skew misleads investors into thinking that mutual fund performance is better than it really is. The same survivorship bias applies to hedge fund performance as well.
Research has demonstrated that survivorship bias causes mutual fund annualized returns to be overstated by between 1.5 and 2% (2). Hedge fund performance is overstated by approximately 6.63% if backfill bias is included. (Backfill bias occurs when hedge fund managers choose not report fund performance to a database from the fund's inception because it is poor and instead choose to "backfill" the database later when they have established a track record of success with a fund).
(2) Sources: “Survivorship Bias and Improper Measurement: How the Mutual Fund Industry Inflates Actively Managed Fund Performance,” Amy L. Barrett etal, March 2006
“The ABCs of Hedge Funds: Alphas, Betas, & Costs,” Roger G. Ibbotson, etal, March 30, 2010
Interestingly enough, while hedge fund returns are significantly overstated because of survivorship bias, hedge funds delivered positive alpha net of fees every year from 2000 to 2010, even through the financial crisis of 2008 and 2009, after being adjusted to remove survivorship bias. The positive alpha is impressive, given that the mutual fund industry does not produce any alpha net of fees when survivor bias is removed.
What should you do about survivorship bias? When you look at historical performance data to determine the most appropriate asset allocation for your portfolio, you should make sure you appreciate the basis on which the performance has been calculated. If the return numbers haven’t been adjusted for survivorship bias, they will probably look better than they really are.
Our database includes all stocks that were delisted or disappeared because of mergers and therefore eliminates any survivorship bias.
Whenever possible, you should evaluate a strategy or fund manager based on a full market cycle that includes a bull and a bear market. Recognized that the 10 or 15 year returns are much more important than the 1, 2 and 3 year returns.
Assess performance based on both risk and reward. If a strategy has higher returns, chances are it also has higher risk and will experience larger drawdowns.
Beware of survivorship bias in the stated annualized returns for categories of mutual funds and classes of hedge funds. The results are almost always overstated.