Digging Deeper into Survivorship Bias
We decided to dig deeper to see if survivorship bias among active managers explains the reality gap. Previous survivorship bias studies have found evidence of survivorship bias, finding an average upward bias in the peer group returns of between 0.10–1.50% per year when portfolios aren’t included in the peer group after they disappear.3 Our analysis found a 0.58% return difference between the median performance of the survivor and survivor-free peer groups for the 10-year period through 2009—well within the range of previous studies. When we eliminate survivorship bias from the peer group analysis, the S&P 500 jumps more than a decile higher and now beats 25% of active institutional managers. Better, but not good enough to explain the reality gap that we see, so we continued to dig.
Most investment strategies are incubated with “seed” capital of a few million dollars to test whether the strategy performs well with live money. If it does, this “new” strategy is added to databases, including its historical track record. Unfortunately, subsequent performance is rarely as good as the initial performance, which leads to another bias in the peer group data. This is known as backfill bias, and studies have found including the backfilled data artificially inflates peer group returns by 1.4% per year.4 To control for backfill bias, we conservatively “netted” down the peer group by 0.50% per year.
A final source of bias relates to fee differentials. Institutions report performance gross of management fees to facilitate apples-to-apples performance comparisons. But, as we outlined earlier, fees matter and are guaranteed to eat into investment returns. Separate account fees for eVestment Alliance’s large-cap core universe range from 70 bps for $1 million to 50 bps for $100 million accounts. Using the middle of the range (60 bps) for active managers and 5 bps for passive management gets us to a 55 bps cost advantage for index funds.
These three adjustments—survivorship bias, backfill bias, and fees—bring the median active peer group 10-year annualized returns down to –0.15%, much closer to the S&P 500 return as seen in Figure 1. And, as believers in the Fundamental Index™ concept know, passive investors can achieve even higher returns by breaking the link between index weights and price. In this case, the advantage is substantial!
Implications for Individual Investors
If the past 10 years is representative, institutional investors face prospective coin-toss odds for active large company management versus passive management. In order to win, they must believe that they can overcome three successively higher hurdles:
- Markets are inefficient, therefore there are ways to beat the market, even though the inefficiencies are presumably constantly changing, with some arbitraged away, only to be replaced by new inefficiencies.
- Some managers have the skill to identify these constantly changing inefficiencies in advance, even though their successes must be funded by failing managers’ mistakes.
- I have the ability to identify these superior managers, in advance, even though my successes must be funded by failing investors’ underperforming manager choices
We must surmount all three hurdles, in order to win. It may sound like we believe the active management game is a fool’s sport. Far from it. But, we do believe it’s a very tough game, which most investors cannot win.
The average individual investor should be so lucky. Without scale to negotiate directly with managers like plan sponsors, mutual fund fees are twice as high. In fact, studies of mutual fund peer groups—which are reported net of all costs—tell a completely different story for the S&P 500 during the 2000s. Even without adjusting for survivorship bias, the S&P 500 ranks in the 60 th percentile in the Lipper peer group and in the 50th percentile for the Morningstar peer group. This is 30–40 percentile ranks better than the gross-of-fees institutional peer group! Adjusting for survivorship bias in the mutual fund peer groups would place the S&P 500 squarely better than the average active fund for the 2000s. And, because many individual accounts are taxable, the results would only get worse after we take into account after-tax returns due to active management’s propensity for higher turnover.5
This type of analysis may not convince active management advocates. But, if ever there was a time period when the stars were aligned and active management should have done very well relative to passive management, it was the decade of the 2000s. In fact, we termed it the “naughties” because of how poorly cap-weighted indexes performed. Entering the decade at epic valuations, the S&P 500 had a 44 times price-to-earnings multiple—nearly three times its long-term average—in 2000.6 The S&P 500 proceeded to lose half its value from 2000–2002, managed to climb back above its high watermark by 2007—but not net of inflation!—and then proceeded to lose half its value again in 2008–2009. After that rollercoaster ride for the S&P 500 and a nice tailwind from active managers’ small-cap bias, the S&P 500 still managed to beat over half its actively managed mutual fund peers, while the average institutional manager barely beat the S&P 500.7
Peer groups are an important part of evaluating the relative merits of any active management strategy. They provide another layer of context, and when used in combination with appropriate benchmarks and time horizons, effectively allow fiduciaries to make well-informed decisions. But, plan sponsors need to understand how peer group rankings are constructed before they use them to evaluate their active managers relative to indexing alternatives. If you control for the effect of survivorship and backfill bias, and net out management costs, the peer group doesn’t beat the S&P 500 by a whopping margin for 10 years. Furthermore, surviving managers—whether at the upper or lower end of the distribution—likely did significantly better than indicated once we take into account many of the failing products that were part of the opportunity set at the time of hire.
There are times when looking at the returns of passive indexes and active peer groups a priori leads to an assumption that active managers are doing a laudable job against the unmanaged indexes—and today is one of those times. The global financial crisis has led to a significant remake of the active manager opportunity set, but don’t let the ever-shifting sands of survivorship and backfill biased peer group returns fool you. Indexing is a smart bet. Importantly, if you want to be a “survivor,” remember the biases of peer groups because what may look like a smart active manager “alliance” could turn out to be a vote off the island of investment success…caveat emptor!