Tuesday, November 9, 2010

You Might be Misled by the Lipper Average (as Seen on T.V.)

Q: When I hear financial companies advertising on T.V., they mention the fact that their funds have beat the 10-yr Lipper Average, what is that and what does it mean?

As Larry Swedroe points out, there are many misleading ways to report performance. The Lipper Average is simply the average level of performance for all mutual funds, reported by Lipper Inc. But let's take a closer look at what data Lipper uses.

In 1986, Lipper reported that 568 stock funds had an average return of 13.4 percent. However, in 1997, Lipper showed the 1986 return to be 14.7 percent. This happened because 134 funds from the original batch disappeared, and their returns were removed from the database. This skew happens by showing the performance of only those funds that are currently in existence. This is known as “survivor-ship bias.” Funds that have poor performance disappear, most often by merging a poorly performing fund into a better performing one. Fortunately, we now have publicly available databases for mutual funds that are free of survivor-ship bias.

Beware, mutual fund companies use other tactics to misled individuals. Including comparing returns to inappropriate benchmarks. For example, a private equity fund, hedge fund or even a value fund might compare its returns to the S&P 500 Index. Each of these funds takes on much greater risk than that benchmark, including the use of leverage. Thus, their returns should be compared to more appropriate, risk-adjusted benchmarks. Many investors have been fooled by this trick.

Also, there’s a third, less well-known bias in mutual fund reporting called incubator bias. Here’s a hypothetical example: A mutual fund company uses its own capital to seed multiple small-cap funds. Each fund might own a different group of small-cap stocks. The fund family incubates the funds, safe from public scrutiny. After a few years they bring public only the fund with the best performance. Magically, the poor performance of the other funds disappears, never to see the light of day.

Unfortunately, the SEC allows fund families to report the pre-public performance of these incubator funds. Thus, we have the potential for a huge distortion of reality, as only successful fund histories make it into the public databases. This is a real problem since the historical evidence is that the past performance of mutual funds has proven not to be prologue.

The bottom line is mutual fund companies attempt to deceive investors through advertising. Of course, there’s a very simple way to avoid the tricks: Just follow the advice you find here and never invest in actively managed funds.

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