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How dead and merged funds have pulled down sector averages by up to 140%

26 August 2015

Passive enthusiasts bemoan studies that don’t take survivorship bias into account. We decided to put their concerns to the test.

By Joshua Ausden,

Head of FE Trustnet Content

Including funds that have either gone out of business or merged has reduced the 20-year return of the IA UK Smaller Companies sector average by 140 percentage points, according to FE Trustnet research.

Sector averages used by FE are calculated in real time and therefore eliminate the impact of survivorship bias, but sometimes figures used to express peer group averages can mislead investors. If, for example, sector averages are calculated using the current constituents of a sector, they wouldn’t include portfolios that have closed.

The issue of survivorship bias stirs up particular controversy when using performance figures in the active versus passive debate. Tracker enthusiasts insist that closed and merged funds are included when calculating the proportion of actively managed funds that have outperformed their benchmarks.

Their concerns are vindicated by our research, which shows that the average fund currently residing in the IA UK Smaller Companies sector has returned 723.44 per cent over the past 20 years, compared with the 583.13 per cent return of FE’s official IA UK Smaller Companies sector average – a difference of 140.31 percentage points.

Performance of sector with and without survivorship bias over 20yrs

 

Source: FE Analytics

Ben Willis of Whitechurch Securities says the majority of funds that have gone out of business have done so because of poor performance, which explains why the return of the official sector average is lower than the average of the current constituents.

His comments are supported by a Vanguard study, which found that the average excess return of funds that went out of business was negative between January 2000 and the date they closed.

The difference in returns is most acute for IA UK Smaller Companies, but the impact of survivorship bias is still significant for the other sectors considered in the study.

The difference in returns for the IA UK All Companies sector over 20 years is 71.22 per cent, for IA Europe ex UK it is 42.91 per cent and for IA Global it’s 40.9 per cent. The difference in returns is less pronounced in IA UK Equity Income (5.47 per cent) and IA Corporate Bond (10.82 per cent), where the range in returns between the best and worst-performing funds has historically been lower.

 

Source: FE Analytics

Exactly why the difference is so great for IA UK Smaller Companies is up for debate, but the risks involved in the sector no doubt play a part.


IA UK Smaller Companies is one of the most volatile sectors in the Investment Association universe, and one of the most volatile of the eight sectors considered by FE Trustnet in this study. The risks involved inevitably leads to some funds suffering heavy losses over certain periods, which increases the likelihood of closures, thus bringing down the sector average more acutely. 

Moreover, the sector is smaller than most of those examined in the study, with only 23 funds currently having a 20-year track record. This increases the impact a dud fund has on the sector average. 

The only instance where including closed or merged funds actually helped the performance of the sector average over 20 years was IA Global Emerging Markets. FE data shows that the official IA Global Emerging Markets sector average has returned 183.17 per cent over 20 years, while the average current constituent has returned 155.17 per cent.

The reason for this discrepancy may be down to the impact of funds which have jumped from one sector to another. The First State Global Emerging Markets fund, which was launched in 1992, consistently topped the sector for long-term returns, but moved into the IA Specialist sector late last year due to a change in its mandate.

As FE’s official IA sector averages are calculated in real time, the strong performance of the fund contributed to the IA Global Emerging Markets sector average right up until October last year. However, the fund is not included in the average of the current constituents, which in this case works against it.

Performance of fund, sector and benchmark over 20yrs

 

Source: FE Analytics

Again, the small size of IA Global Emerging Markets (only 11 have a 20 year track record) compounds the impact that this top-performing fund has on the sector.

To cite another example, the Invesco Perpetual High Income and Invesco Perpetual Income funds moved from IA UK Equity Income to IA UK All Companies in mid-2014 due to their failure to hit their former sector’s yield target.

Again, the performance of the Invesco funds contribute to the official IA UK Equity Income sector average for the majority of the 20-year period, but are not included in the average of the current constituents. Given that these are among the best-performing UK funds over the period, this may go some way in explaining why the difference in returns for IA UK Equity Income is less pronounced than most.

While the difference in returns is predominantly down to the impact of survivorship bias, the movement of funds between sectors also plays a part in this study. Regardless, the findings show just how misleading sector averages that have been formed retrospectively can be. 


Inevitably, the impact of survivorship bias decreases over shorter time periods, though the difference in returns is in most cases still significant.

Performance of sector with and without survivorship bias over 10yrs

 

Source: FE Analytics

Over 10 years, for example, the IA UK Smaller Companies sector has returned just under 30 percentage points less when dead and merged funds are included. The difference is 12.6 percentage points for IA Global and 10.35 percentage points for IA Europe ex UK.

FE Trustnet will further examine the impact of survivorship bias in an upcoming study examining the proportion of active managers that have beaten their benchmark in recent years. 

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.