A Chilling Lesson From Dead Investment Funds

Published in Investing Strategy on 12 November 2010

They're gone. But this is how much they cost you.

You thought that investment funds were bad news? You were suspicious of their high charges, murky investment processes, and propensity to hug their respective benchmarks?

Well, congratulations: you weren't wrong. Here at The Motley Fool, we've long taken a dim view of investment funds. But here's the kicker. New research shows that you were in fact more correct than you might have suspected.

And that's because by the time the figures are usually compiled, the bodies have quite literally been buried.

Survivorship bias

It's comparatively rare for detailed analyses of active investing -- taking into account every fund on the market -- to be carried out. Back in the early days of the Fool, I remember reading some statistics pointing out that most funds underperform the market, but I haven't seen very much detailed research since.

But these 'whole market' analyses, by definition, actually turn out to miss out a whole swathe of funds. That's because they look only at the funds that are presently on sale in the market.

And as research published this week by passive fund management firm Vanguard points out, that's an important omission:

"Prior to this research, publicly available fund performance returns have overstated the effectiveness of active management by only including surviving funds, not those that had been merged or closed. This 'survivorship bias' must be considered, as the returns from liquidated funds disappear from the data, providing a distorted view of the performance of actively managed funds."

Cadavers unearthed

And you won't be surprised to learn what including the performance of those funds that didn't survive does to the analysis. Let's put it this way: they weren't closed down because they were rip-roaring successes.

In fact, over an eighteen-month period prior to their termination, these liquidated or merged funds performed, on average, 2.65% below their respective benchmarks.

And taking this survivorship bias into account, it turns out that over five years, only about 25% of actively-managed UK equity funds investing in large companies did better than the FTSE 350.

Er, yes: you read that correctly. And put another way, it's even more stark a conclusion. Three quarters of them didn't outperform the FTSE 350.

And a similar story, it seems, can be found in the UK actively-managed bond sector. Over five years, the apparent outperformance of a majority of government and corporate bond sectors evaporates when closed or merged funds are included in the analysis.

Costs matter

Long-time Fool readers won't be surprised as to why this under-performance arises. It comes down to costs, in short.

Investing is a 'zero‑sum game', says Vanguard: for every winner, there has to be a loser. So in practice, on average and over time, managers of active funds will underperform the index due to costs. In other words, after costs are accounted for, investing becomes 'less than a zero‑sum game'.

And while some active managers do outperform the market, identifying persistently-outperforming funds in advance is extremely difficult. Vanguard's analysis highlights that only 22% of top-ranked funds in the five years to 2004 remained in the top rank over the subsequent five years to 2009.

In fact, a top‑performing fund over the five-year period to the end of 2004 was almost as likely to end up in the bottom 20% per cent band over next five years as it was to staying in the top band.

And shockingly, there was a 42% chance that a top‑ranked fund would go on to underperform in the following five‑year periods, or be closed or merged.

Banging the drum

Now, Vanguard isn't going to the trouble and expense of performing such analyses out of the goodness of its heart. There's an agenda, and a very clear one.

Famous in the US market for the low-cost index trackers created by founder John Bogle, Vanguard is trying to gain the same traction over here as it has over there.

And this research is intended to underpin the merits of passive investment in the sorts of low-cost funds that Vanguard excels in.

But with that health warning in place, the argument in favour of passive investments such as index funds is very clear cut. The total expense ratio for the average UK-domiciled equity index fund is 0.8% compared to 1.7% for the average actively-managed fund.

And why pay double the costs when the investment outcome is no better -- and possibly worse? It's an argument that it's difficult to refute.

More from Malcolm Wheatley:

> Malcolm holds trackers from Vanguard in a SIPP and ISA.


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Luniversal 12 Nov 2010 , 4:40pm

As always, a sharp difference should be drawn between the boutique-ey, gimmick-ridden world of mutual funds (unit trusts and OEICs) with their 'styles', 'themes', star managers etc, as opposed to plodding old investment trusts. The former get all the heavy money and attention because Wise middlemen get sweeteners for pushing them.

The 'Basket of Ten' and 'Basket of Seven' ITs I am advocating for income contain none less than 14 years old, most at least 40 years old and some dating from Queen Vic's heyday. Sheer survival in recognisable form is a recommendation. So is the generalist investment trusts' refusal to milk holders by rights issues, to change year ends or alter mandates, to go for broke on the latest fancied sector or territory. Their benchmarks are plain and broad, and they measure results by both capital and revenue outcomes as the law insists.

The very names quaintly exhale continuity: 'British Empire', 'Foreign & Colonial', 'Scottish American', 'Bankers'.

Whereas your typical go-go fund has the fluidity of an amoeba that wants to be a chameleon. And it is far less circumscribed by legalities than a trad Scotch investment trust, which must get positive votes of approval from shareholders for all sorts of corporate actions... and for its very existence every five years.

Vanguard is right: there is a colossal bias in fund stats-- coupled with the bundled-up idiocy of Total Return as the main yardstick of success-- so that it ought to be called 'transformation bias'. For a failure need not fold; it can change objectives in a heartbeat without telling its holders, as one of my UK income funds did the other day, abruptly announcing it was now a GLOBAL income fund with a shiny new name.

To me this suggests that within an asset allocation scheme you should shoot for income by way of direct investment or the low-cost big ITs, and for capital growth seek out the cheapest market tracker(s) you can lay hands on, such as Vanguard's. Why pay a total expense ratio of 1.5-2.5% pa (and up to 5% front end load if you're particularly clueless) so these 'professional' clodhoppers can mess with your money?

Avalaugh 12 Nov 2010 , 10:19pm


How about funds like JPM Natural Resources, they may charge a fee however it isnt easy to invest in the type of stuff they buy directly?


supersol42 15 Nov 2010 , 1:52pm

Unit trusts were invented because, unlike investment trusts, they cannot borrow money. Borrowing money to buy shares is a bad idea; in 1931 some holders and managers of investment trusts threw themselves off skyscapers.

With a unit trust, those managing it have no interest at all in the assets. Legal ownership is with the trustee, but it has no beneficial interest. All the actual value is owned by the unit holders. Brilliant!

Certainly, it is unwise to pick a fund because it happens to have a "star" manager; this individual will die, fall ill, retire, or move on.

It is better to choose a fund with a rubric which has a sporting chance, and which survives any change in the identity of the chaps and ladies actually choosing the shares. Such are, for example, M&G Recovery and Templeton Global Growth.

tux222 15 Nov 2010 , 2:16pm

I much prefer investment trusts because, for most of them most of the time, you are buying the underlying assets at a discount. If you buy at a 10% discount, the yield is 10% higher. As a consequence, if the trust's management is charging a fraction of a percent, you are in effect getting it for free.

Another reason to prefer investment trusts is that they cannot be forced to sell into a bear market by a large fraction of their investors taking fright. Instead, the market takes the strain. The discount widens, the underlying investments are retained, and if you are the contrarian who buys when the crowds are selling, you do well if/when the market recovers.

onthebeach4 15 Nov 2010 , 3:35pm

Dear Malcolm,

Whoever writes this article (it appears regularly) NEVER gives any examples of trackers which have beaten managed funds. How about it? You choose the sector and the timeframe.

It's a bit like the quote from Fidelity that if you're out of the market and miss out on the the best so many days you will loose a fortune but they never say that if you miss out on the worst so many days you will save a fortune.

I want to believe so come on back these claims up with facts.

Luniversal 15 Nov 2010 , 6:34pm

"in 1931 some holders and managers of investment trusts threw themselves off skyscapers."

Not the sort of solid, boring investment trust I was talking about. In fact there was remarkably little read-through from the scandals of pyramiding, margin dealing and overborrowing that infested the US scene in the 1920s. The British IT business-- apart from the gimmicky kind of vehicle which is much more often found on the OEIC beat-- is very level-headed and has navigated all sorts of crisis well.

Yes, they can gear up, and yes, they can get it wrong. But the kind of trust I like rarely has more than 20% gearing, and assets are easy to liquidate if a manager wants to pay down debt in a hurry. You don't find Big Dull Scotch Mortgage Trust coming cap in hand with a rights issue because it misjudged interest rates.

As another Fool has said, the trouble with open-ended funds is how fashion-addled investors' money sloshes in and out, forcing them to make policy on the hoof or in a panic. To my mind this is much more potentially destabilising than a debenture stock or two in a trust's balance sheet.

Tara1492 15 Nov 2010 , 7:22pm

Apart from the split cap debacle I would agree, investment trusts are a great way to invest - the only think I don't like about them is so many have tobacco company shares which I try to avoid.

MDW1954 15 Nov 2010 , 7:23pm

Hello onthebeach4,

You're on!

Malcolm (author)

scotsboy1 15 Nov 2010 , 8:03pm

When it comes to picking "Star managers", I like Buffet(?) who said pick a company which could be run by monkeys - because one day it will be.

The same principle holds for active funds - so I prefer Investment Trusts

afamiii 15 Nov 2010 , 10:26pm

I bought a house in 2000 with an interest only mortgage. At the same time I set up standing orders into 3 L&G index tracking trusts (UK, Pacific and Japan) in all 3 cases the index trusts outperformed L&Gs equivalent managed trusts (even if you equalise the management fees they still underperformed,)

My only other experience with the fund industry has been with Barclays Pension Managers. As a youth (comparitivly) I opted out of SERPS in 1993. My active fund Manager Barclays Pensions has managed to deliver 2.1% average annual return over the past 17 years. Out of equities!

Fortunately, I don't have much faith in the financial services industry and also fortunately I enjoy developing my own knowledge, skill and experience, doing my own searches and analysis and buying the assets that I believe will give ma stable future.

Good luck to those who give their money to strangers and hope that they will treat it will still be there when they need it back.

afamiii 15 Nov 2010 , 10:27pm

PS: And the index trusts underperformed the indexes even when you take out the low fees???

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