By Jason Zweig | Jan. 16, 2017 7:30 p.m. ET
Image credit: Eastman Johnson, “Bo-Peep” (1872), Amon Carter Museum of American Art
Can bad returns be buried? Can good returns be created out of thin air? Here’s a look back at the games that mutual funds used to play with performance — and that some still do. The rules limiting an investment manager’s ability to report past returns on other accounts as if they were earned by mutual funds remain murky. And survivorship bias — in which losing funds are scrubbed from the historical record, making the past look better than it was — is still common. The basic questions raised by this column, which I wrote nearly two decades ago, remain relevant for investors today.
With some mutual funds, past returns can’t even predict the past.
Money Magazine, Dec. 1998
Just as I was running out of new reasons to warn you that past performance tells you next to nothing about the future, the mutual fund industry has bailed me out again. Now, at the turn of the year, is when investors look back and make new investments based on how a given fund or a category of funds has fared lately. But performance can fool you in new and tricky ways, thanks to little-known changes sweeping through the fund business.
If you’ve ever played touch football, you know what a “do-over” is: When a play goes awry, both sides agree to start again, and what happened on the previous snap of the football doesn’t count. The fund industry has its own do-overs. If a fund earns lousy returns over time, its managers can get rid of it (by merging it into a sibling fund, selling it to another operator or sending investors’ money back). That erases the fund’s bad record from history. According to filings at the Securities and Exchange Commission, at least 29 funds officially disappeared in August and September 1998.
Then there’s a second kind of do-over, in which an investment manager takes money that was run in another form — say, a bank trust fund, a limited partnership or an insurance company “separate account” — and puts it in a new container. These do-overs are big business. Financial Research, a Boston consulting firm, estimates that 27% of all the cash that flowed into stock and bond funds last May — more than $8.4 billion — came through conversions of bank trust funds.
Sometimes these bank pools are merged into existing mutual funds. But in other cases, a mutual fund is created from scratch to hold the converted assets. Then this newborn mutual fund gets to swaddle itself in the cloak of the bank fund’s long-term performance. It’s as if a baby had popped out into the delivery room already fully clothed, fully grown and asking for the keys to the family car.
But who’s counting?
And so the fund industry, which had already bewildered investors by hatching hundreds of copycat funds, has created the ultimate “chicken and egg” confusion: Which came first, the fund or its performance?
Nowadays, you need to hire an astrologer to tell you exactly what — and how long — a fund’s track record is. Go to the BlackRock Funds’ website, and you’ll find returns over the past one, three and five years for the BlackRock GNMA Bond Fund. You’ll also see that, as of Sept. 30, this portfolio had an 8.03% annualized total return “since fund inception.” Since it’s listed in a block with seven other BlackRock bond funds with long-term histories — and its own “five year” record is displayed — you’d assume this mutual fund dates back to at least 1993.
I’ve got news for you. BlackRock GNMA Bond did not even exist as a mutual fund until last May; before that, it was one of PNC Bank’s common trust funds. To calculate the return “since inception” as shown on its site, BlackRock began counting in June 1990, when GNMA Bond began its previous incarnation as a bank trust fund — eight full years before it became a mutual fund. (The website discloses this only in the cyberspace equivalent of fine print.)
Meanwhile, Lipper Analytical Services and Morningstar, the providers of fund performance data, say Black Rock GNMA returned 3.3% from its inception — just last May — through Sept. 30.
Is this a mutual fund, or is it Shirley MacLaine? According to guidelines set by the SEC in 1995, if the trust fund held substantially the same securities and was run in the same manner, the mutual fund can report the trust’s old returns as if they were its own. (The past results must be restated to account for the mutual fund’s higher fees.)
“The differences [between the trust fund and the mutual fund] were not material,” says BlackRock Funds president Karen Sabath. “The portfolios were extremely similar.”
That’s been true since 1995, when PNC bought BlackRock. It’s less clear before 1995, when the fund had different managers. Moreover, until this year it was sold only to the bank’s private trust clients, not to poor slobs like you and me. Its net asset value was disclosed — and shareholders could buy or sell — once a week at best. That’s hardly the same as a mutual fund, which must let investors in or out at net asset value every day.
That was then, this is now
I personally believe that the records of the BlackRock fund and its predecessor trust truly are comparable, at least since 1995; the rocket scientists at BlackRock run their mortgage bond portfolios with so much computing power they’d make a Tom Clancy hero twitch with envy. Nevertheless, there’s no doubt that in many cases investors need to take fund returns with a new grain of salt; if a portfolio began life as something other than a mutual fund, you’d be unwise to assume its future will closely resemble that alien past.
The prospectus for the Euclid Market Neutral Fund, for instance, concedes that the fund had no track record before its birth in May 1998. But it does show how you would have fared since January 1990 if you’d invested in “a composite” of Euclid’s other accounts “that are substantially similar to those of the fund.”
Transamerica Premier Equity, meanwhile, began life in October 1995, yet its prospectus kindly points out that the “segregated investment accounts (or ‘separate accounts’)” of Transamerica’s pension clients earned 28.14% annually over the 10 years that ended last March 31 — while the S&P 500 rose just 18.94% annually.
But “composites” and “separate accounts” are not mutual funds. Composites, separate accounts and mutual funds are all pools of money run by professionals. Then again, lemurs, chimpanzees and humans are all primates — and that hardly makes them the same. So you should pay attention when the Transamerica prospectus goes on to warn that these returns “should not be considered a substitute for the fund’s own performance.” And the Euclid prospectus admits that if its “other” accounts had been run under the stringent rules governing mutual funds, “their performance might have been adversely affected.”
That’s the stuff you should take to heart in these prospectuses — not the returns that you might have earned if you could have bought a mutual fund before it even existed. That’s why you should read fund prospectuses from the back. (If the fund company would prefer that you not notice something, I guarantee you it’ll be near the end.) Read the small type before the big type. And remember that the footnotes in prospectuses are like the hedgerows in war movies: That’s where the ambushes come from.
One other thing: Even if your fund hasn’t been through a do-over, these performance switcheroos can distort the historical averages that you may have relied on to choose which kinds of funds to buy.
Ernest Ankrim, director of portfolio research at Frank Russell Co., the Tacoma, Wash. pension consultant and fund manager, has estimated the overall impact of these do-overs. In the summer issue of the Journal of Performance Measurement (aren’t you glad I read this stuff, so you don’t have to?), Ankrim studied dozens of institutional money managers from 1988 through 1996. He found that the average track record over that period was overstated by between 0.14 and 1.86 percentage points annually, as bad funds were buried and good ones were introduced after the fact. (Portfolios of bonds and large-company stocks showed the least change; small-caps and international showed the most.)
Explains Ankrim: “When you look back and think, ‘If I’d just picked the average fund in that category, I could have earned that,’ the number is overstated, and it’s overstated even more than we thought.” And that means buying a fund solely because it’s in a category with high average returns — “I want an aggressive growth fund, since they’ve beaten the market over the past five years” — may well be a mistake.
When I think about what’s happening to performance measurement, I remember a wisecrack that Eastern Europeans used to make under Communist rule: “Our history is even harder to predict than our future.” Given how hard it has always been to predict future investment results, the muddling of mutual fund history spells nothing but trouble. Your only defense as an investor is to make sure you ask even tougher questions than ever about how a fund earned its record — and who earned it, and in what form.
Source: Money Magazine, Dec. 1998
Definitions of PERFORMANCE and SURVIVORSHIP BIAS in The Devil’s Financial Dictionary
For further reading:
Edwin J. Elton et al, “Survivorship Bias and Mutual Fund Performance” (1996)
Mark M. Carhart et al., “Mutual Fund Survivorship” (2002)