Last week in my February Investment Update I had a chart similar to many a chart found in Mutual Fund advertising. Unlike charts referred to most advertising, I haven’t been beating the indexes since inception. I’ve been mostly lagging until this most recent market downturn. As I created the chart for myself, I was more accutely aware of how misleading such charts can be for reasons even though I was cognizant of I still don’t give enough attention to. It’s one thing to know but another to implement.

It’s rare that you’ll find a Mutual Fund advertising a chart where it lags the market. Why is this?
1) Survivorship Bias
2) The lasting effects of early superior performance

Survivorship Biases
The fact is that mutual funds that are sold are generally ones that have survived some type of incubation period. The average investor does not see the dreck that is started then killed. Most mutual fund companies will start a number of new funds, and from these only a handful will make it to mass market. Funds in incubation are generally open to just employees or select investors. As much as it might seem like a privilege, it’s really not. The incubation process allows a fund company to employ a couple different strategies which can be diametrically opposed. For example, maybe I think Dell (DELL) Computer will get it’s act together and take back market share from Hewlett Packard (HWP), so I start one fund, fund A, and buy many shares of Dell. However at the same time I start fund B and buy tons of HWP just in case. If Dell proves successful, fund A does well, and if HWP reigns supreme Fund B is a winner. Heads I win, Tails you lose. Depending on what happens, a fund company can kill whatever fund is a loser and only market the winning fund. This is survivorship bias at it’s cruelest.

Resting on the Laurels
Once a fund achieves superior performance, it can rest on it’s laurels as far has historic performance charts are concerned.

On that chart I added two Alternative performances. Instead of returning -1% in March 2006, my alternative portfolios returned -8% and +8%. Other than difference in returns for that one month, the performance is the same. It’s clear how one good a month can make my portfolio look like an incredible winner. This type of performance is very typical in many actively managed mutual funds because of the incubation process. Mutual fund companies incubate a “winner” and then start advertising that fund with these nifty charts demonstrating market beating performance. The caveat that often accompanies these charts is that, “historical performance is not an indicator of future returns.” All too true.