Survivorship Bias and Mutual Fund Performance 

At the time of investing in a mutual fund, an investor commonly looks at the past performance of funds and, based on this, compares it with other funds. But have you ever wondered what will happen to the funds that had performed poorly and disappeared from the market?

In today’s blog post, we will give you an overview of survivorship bias and how it can impact mutual fund returns.

What is the meaning of Survivorship Bias?

Survivorship bias is an error in an analysis that focuses on investments, funds or companies that have survived until the end of a particular period and ignores those that failed or were discontinued. Simply put, this bias considers only the winners that are still around and forgets the ones that did not survive. The returns of the funds that disappeared are left out of the analysis.

What is Survivorship Bias in Mutual Funds?

When it comes to mutual funds, survivorship bias generally happens when investors evaluate historical fund performance by considering only schemes that are currently available for investment. It happens when an investor looks at the current list of equity mutual funds and identifies the funds with the best five-year returns. These funds may appear to have performed consistently well over the entire period. However, this analysis does not include the funds that existed five years ago but were later merged or closed after poor performance. Due to this, the investor may get the impression that the long-term mutual fund performance was better and more consistent than it actually was.

Example of Survivorship Bias 

Let’s understand survivorship bias through an example.

There were 10 mutual funds available in an equity category during the year 2015. An investor named Mr X decided to analyse the performance of this category over the last 10 years. After 10 years, only 7 funds are still available. The remaining three funds were merged with other schemes or discontinued because of reasons such as low performance and less interest from investors. Now the 10-year returns of the remaining 7 funds are as follows.

Fund Name	10-Year Returns
A	15%
B	14%
C	13%
D	12%
E	11%
F	10%
G	9%

In this case, the average return of these funds is 12%. Based on this data, the category appears to have delivered an approximate return of 12%. However, the 3 funds that were closed or merged are not included in this calculation. 

Now let us include the three closed funds. Suppose their annualised returns until the date of closure were as follows:

Fund Name	Return Until Closure
H	4%
I	2%
J	-3%

The average return of all 10 funds is 8.7%. So the true category return was about 8.7%, not 12%. Survivorship bias overstated the category return by roughly 3.3%.

How Does Survivorship Bias Affect Mutual Fund Performance

Survivorship bias affects mutual fund performance in the following manner:

1. Overstating the Average Return: If the investor ignores funds that have been discontinued or merged with some other scheme while calculating the average return, this may cause overstating the average return.
2. Consistent Performer: A fund that has a consistent performance record and has survived for many years may ignore the funds that have performed poorly and disappeared during the same period.
3. Easy Fund Selection: When an investor looks only at today’s top performer with the benefit of hindsight, it seems that picking these funds years ago was easy. The funds that looked equally promising but failed are not visible. 

Why Do Mutual Funds Disappear?

The common reasons why mutual funds disappear are as follows:

1. Underperformance: If a fund consistently performs poorly or fails to deliver consistent returns, the AMC may decide to discontinue or merge the scheme.
2. AUM: When a mutual fund scheme has very low assets under management, it may not be practical for the AMC to continue such funds because of operational and administrative costs.
3. Change in Investment Strategy: There may be some cases when the scheme investment objective or strategy changes. Instead of continuing the existing fund, it may merge or restructure.
4. Lack of Interest: If the investors show very little interest in a particular category or scheme. It may decide that continuing is not worthwhile.
5. Regulations: If the regulatory authority changes the rules related to mutual fund categorisation, the asset management companies are required to close or merge the scheme.

Read Also: How to Evaluate Mutual Fund Performance in India

Importance of Survivorship Bias

The key importance of survivorship bias is as follows:

1. Real Picture: Analysing both surviving and discontinued funds provides a better idea of how a category has performed over time. It reduces the risk of judging the entire category only by its successful funds.
2. Avoid Misleading Conclusions: If the poorly performing funds are removed from the data, then the average return may look higher than it really was.
3. Understanding Investment Risk: A fund category may be less risky only when the successful funds are considered. Funds that have performed poorly may provide a better understanding of possible ups and downs.
4. Comparing Categories: Survivorship bias can impact the comparison between different categories of mutual funds. It helps investors make fairer comparisons by relying on the performance of funds that are still available. 

What Is the Difference Between Survivorship Bias and Other Investment Biases? 

Survivorship bias ignores failures, while other investment biases stem from emotions, assumptions, and market trends. 

Investment Bias	Meaning	Example
Survivorship Bias	Focusing solely on the successful investments and ignoring the failed ones and the ones that have been discontinued.	Evaluating mutual fund performance by looking at only those funds that are still in existence.
Confirmation Bias	Favours information which supports existing investment views.	Read only the positive news before you invest in a stock.
Herd Mentality Bias	Following other investors’ decisions without independent research.	Buying a stock because it is trending among investors.
Recency Bias	Giving excessive weight to recent market performance when attempting to predict future returns.	Investing in a fund simply because it delivered such good returns last year.
Overconfidence Bias	Overestimating one’s ability to predict market movements or select winning investments.	Taking excessive risks after a few successful trades.

Impact of Survivorship Bias

The key impacts of survivorship bias on the performance of mutual funds are as follows:

1. Overestimation of Past Returns: Funds that have succeeded are the only ones included in a study, so the average return could be higher than reality.
2. False Performance: An investor could be misled into thinking that most of the mutual fund is doing well because only surviving funds are visible. 

3. Understanding Risk: Funds that are not doing well are supposed to disappear from the data set, thus making the overall category less dangerous compared to reality.
4. Impact Mutual Fund Research: Mutual fund analysis could be concluded erroneously as to how well a category did. 

Avoiding Survivorship Bias

The common ways to avoid survivorship bias are as follows:

1. Include Closed Funds: At the time of analysing the performance of a mutual fund category, one must consider funds that were closed, merged or discontinued instead of considering only funds that are currently available.
2. Compare Same Duration: One should consider the fund performance only for the same period to prevent newer or recent funds from getting an unfair advantage.
3. Risk-Adjusted Returns: An investor should not only focus on return; other factors such as Sharpe ratio, maximum drawdown, etc., should be considered while analysing historical data.

Read Also: How to Build a Mutual Fund Portfolio

Conclusion

On a concluding note, survivorship bias can allow investors to understand a broader picture of mutual fund performance. The closed, merged, or discontinued funds may not be covered when analysing returns of the funds that are still active today for various reasons. The past may seem more impressive than it was in reality, and risk can be underestimated. So investors should also take into account the risk, consistency, investment strategy, and the market conditions. After grasping real risk, a broader and unbiased view can assist investors in making informed decisions. But it is recommended that anyone shouldn’t invest based on returns only and should invest only after taking advice from their investment advisor.

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