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tmacpherson1966
tmacpherson1966
Articles (144)  | Author's Website |

Mutual Fund Survivorship: The Revenge of Abraham Wald

January 02, 2015

The story of Abraham Wald and the study of WWII bomber casualties is one of the more enlightening stories from the field of operational research. During the early days of the Allied strategic bombing campaign the amount of bombers not returning from their missions reached an unacceptable rate. In a desire to find out why, the USAAF completed a study on where the damage was taking place and where additional armor could be placed to make each bomber safer. Here Wald enters our story. Taking one look at the methodology and findings, Wald told the team they were looking at the problem the wrong way. By studying the planes that came back the researchers were seeing where the planes could withstand damage. The more interesting facts should be about the planes that didn't make it back. By analyzing where all the bullets holes and damage were on the planes that made it back, he proposed strengthening the areas where there were no bullet holes. Through his report thousands of bomber crewmembers were saved through the course of the war. Wald’s report and methodology can be found here.

Wald’s technique would later be summarized quite pithily by Charlie Munger (Trades, Portfolio) when he advised, “Invert. Always invert.” The use of Wald’s methodology can be applied in the investment world in many ways. Perhaps the greatest use is the study of mutual funds. Investors spend an inordinate amount of time studying mutual funds with fantastic records (such as Bill Miller’s Legg Mason Capital Management Value Trust fund during the 1990s). Put in Wald’s context, these are the funds that made it home. But what about all those funds that didn't survive? The funds that didn't make it home? What can be learned from these?

Before we get to that, let’s take a look at the numbers of mutual funds and find out their general survivor rate. In 2013 Vanguard released a study on fund survivorship (which can be found here) studying mutual funds from 1997 through 2011. At the start of the study period there were 5,108 funds available. By the end of 2011, 2,364 of these funds had been closed or merged, leaving 2,744 funds (or 54% of all funds) that survived for the entire period. In that period from 1997 through the end of 2011 roughly 1 out of 2 funds didn't make it home. Of the funds that didn't make it, roughly 80% (or roughly 1,900) were merged away while the remaining 20% (roughly 470) were closed entirely.

It’s how the funds performed where the story gets very interesting. Let’s start with the funds that existed for the entire period (or the funds that made it home). Of the 2,744 funds roughly 1/3 ended up outperforming. During the period of 1997 – 2011 - even if you could divine which fund might actually survive - you still had roughly a two-thirds chance at underperforming the market.

Fund

Category

# of Surviving Funds

%

Under

Perform

# Out

Perform

#

Under

Perform

Global Markets

124

35%

81

43

Developed Markets

259

35%

168

91

Emerging Markets

64

53%

30

34

Large Blend

280

65%

98

182

Large Growth

326

66%

111

215

Large Value

261

50%

130

131

Mid Cap Blend

64

94%

4

60

Mid Cap Growth

174

89%

19

155

Mid Cap Value

45

100%

0

45

Small Cap Blend

78

58%

33

45

Small Cap Growth

158

65%

55

103

Small Cap Value

55

56%

24

31

Sector Funds

138

30%

97

41

U.S. Government Bond

220

71%

64

156

U.S. Corporate Bond

379

85%

57

322

U.S. High Yield

119

90%

12

107

TOTALS

2744

983

(36%)

1761

(64%)

Let’s take a look at the funds that didn’t survive the period (or the ones who didn't make it home). Here the story is far more depressing. Roughly 9 out 10 funds underperformed before they were either merged away or simply closed. A loss that would have staggered Wald himself. It’s hard to imagine that trained professionals – with a wealth of technology, analytics and treasure behind them – couldn't exceed the batting average of a Double-A baseball team third-stringer. In fact it’s hard to imagine that throwing darts at a list of stocks and bonds couldn't have produced better results. For the investors who received such terrible returns from their investment managers, all they received was a letter quietly delivered to their mailbox informing them of the merger of their fund with an entirely new – and no doubt exciting and outperforming – investment opportunity.

Fund

Category

# of Dead/

Merged Funds

%

Under

Perform[1]

# Out

Perform

#

Under

Perform

Global Markets

106

88%

13

93

Developed Markets

179

79%

38

141

Emerging Markets

54

53%

25

29

Large Blend

286

96%

11

275

Large Growth

283

93%

20

263

Large Value

212

80%

42

170

Mid Cap Blend

56

96%

2

54

Mid Cap Growth

166

100%

0

166

Mid Cap Value

48

95%

2

46

Small Cap Blend

59

94%

4

55

Small Cap Growth

133

83%

23

110

Small Cap Value

30

91%

3

27

Sector Funds

83

72%

23

60

U.S. Government Bond

269

90%

27

242

U.S. Corporate Bond

341

96%

14

327

U.S. High Yield

59

84%

9

50

TOTALS

2364

256

(11%)

2108

(89%)

What would Abraham Wald say?

Wald approached the problem of aircraft losses very differently than the original assessment team. His ability to flip (or invert) the model allowed him to address the problem with an entirely fresh (and as it turns out – correct) approach. If we apply his methodology to the mutual fund industry there are several points that jump out that go far beyond the usual Wall Street talking points.

It’s not about succeeding; it’s about not failing

In the investment world, action represents success. In reality, active management (or action) represents a losing proposition. There’s an old adage that 90% of success is just showing up. It would seem the same rings true in investing – but with a twist; 90% of success is showing up, investing and doing nothing. Actively managed funds have demonstrated they have very little chance at beating the market indices. Indeed, if you add in the silent results of the funds that never made it, the odds of outperforming the markets are roughly 2 in 10. Active management – in general – is a loser’s bet. As personal investors this has equal import. By not making the simple mistakes – overpaying, trading too much, etc. – we can achieve remarkable returns. By not failing, we can provide our investors an invaluable service.

Evaluate an investment backwards

Many of us have a formalized process for evaluating investing opportunities. Some might use a DCF model while others use a dividend discount model. All too often we find comfort in using this process, and we get lulled into a false confidence in our stock picking. At Nintai, we frequently ask ourselves why we wouldn't invest in a certain company. By being the devil’s advocate, we get a pretty good understanding of potential impairments to our investment case. Another tool is to build into your model the exact opposite assumptions and see where you end up. For instance if you project 8% FCF growth over the next 5 years, what would it look like if the company had -8% FCF growth instead. What impact would that have on EPS, balance sheet, etc.? Finally, we step away from our assumptions and become a competitor. What could I do strategically to beat the company? What new products could I develop? Do I have the financial ability to acquire them? All of these (and others) allow us to view our prospective investment from very different angles than our normal proprietary process.

Conclusions

Abraham Wald saved tens of thousands of flight crew lives during World War II. His ability to see things from a different perspective allowed him to solve a critical failing in the Allied war effort. More importantly he demonstrated the power of survivorship bias and how it can lead us to misguided assumptions. For investors – both mutual fund and individual – we can be blinded by our successes and not take sufficient care to understand and protect against the downside. That’s a shame. Sometimes there are more learnings from a mistake than a success. I encourage everyone to take a long, hard look at his or her failed investments and find out what went wrong. Sometimes simply getting these corrected is far more powerful than looking for the next Microsoft. In the final analysis the solution can occasionally be blindingly clear with a simple move to the left or right. Just ask Abraham Wald.

As always we look forward to your thoughts and comments.


[1] Percent underperforming from 01/1997 to close/merge date

About the author:

tmacpherson1966
Thomas Macpherson is Managing Director and Chief Investment Officer at Nintai Investments LLC. He is also Chairman of the Board at the Hayashi Foundation, a Japanese-based charity serving special needs children and service pets. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

Visit tmacpherson1966's Website


Rating: 5.0/5 (5 votes)

Voters:

Comments

rdj1234
Rdj1234 - 4 years ago    Report SPAM

Very thought provoking! I'm printing this one to go into my checklist articles.

Thank You

Roger

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Thanks Roger for your comments. I'm glad you found the article interesting. Everyday we seem to learn something as we try to become better investors. We find the field touches on so many issues - psychology, organization theory, probability, etc. I wish you much success in your investing endeavors. Best wishes for a happy and healthy New Year. - Tom

Jackov
Jackov - 4 years ago    Report SPAM

It's great that you document all the things that you speak about.

Too many writers simply ask readers to "trust them" without providing any reasons that we should.

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Thanks Jackov. I think it's important we also use data and evidence to support our thesis. Otherwise your opinions can float away on you like a balloon with no ballast. My best wishes for a happy and healthy New Year.

Open Mind Learning
Open Mind Learning - 4 years ago    Report SPAM

Brilliant extension and explanation of Munger's famous phrase..." invert, Always invert".

Thanks for sharing and best wishes for the New Year.

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago
Thanks Navindevay. I'm glad you enjoyed the article and thank you for your very kind words. It's pretty hard to improve on Charlie Munger (Trades, Portfolio)'s wisdom. My best wishes for a happy and healthy New Year. - Tom

rdj1234
Rdj1234 - 4 years ago    Report SPAM

I looked up Abraham Wald after I read this, and sadly he and his wife died in a plane crash in 1950.

Irony can be cruel.

Roger

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Yes RDJ. He died far too young. The irony certainly didn't escape many who studied his research. - Tom

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