Opening the Cold Case Files of Investing
If you watch any amount of television at all, you’ve probably heard of the A&E series Cold Case Files. It’s popularity is largely due to the fact that it reopens and investigates a variety of long-unsolved mysteries, which are referred to as “cold cases” in detective jargon. Now equipped with DNA techniques, criminal psychology, and other breakthroughs in technology, what once was thought to be a dead-end, can now be reopened and solved beyond the shadow of a doubt. That’s how far we’ve come in technological advancements.
Well, the world of investing is no different. Statistics and information that we’ve blindly believed to be true for years suddenly can be examined in a whole new way. Things aren’t always what they seem, and with Mutual Funds, there are quite a few ways that data has been cleverly and selectively manipulated over the years. Unfortunately, the bad guys aren’t being hunted down by detectives and the police like they are on the television show. Instead, they’re much more difficult to recognize. Let’s take a look at how time has “uncovered” some of the lies we used to believe.
The Beardstown Ladies Debunked
Some of you may remember the bestselling book called The Beardstown Ladies from the 1990s. It centered around a group of ladies who supposedly produced amazing returns (an average of 23%) over a ten year period. That, to say the least, would be absolutely incredible. They received sweeping attention from national media outlets during this time period, and their Common-Sense Investment Guide was followed up by four more books. They really had the corner on investing and certainly, scores of investors read their advice as if it were Biblical truth. Unfortunately, it was later discovered that none of these claims were actually documented, and there weren’t any audits to back any of the information up.
It was later revealed that the calculations leading to the 23% were incorrect. Surprise, surprise. They were actually counting their membership dues along with the returns. Oops.
In reality, the ladies were pulling in 9% per year, which is good, but since the market was doing 15%, this figure was not nearly as impressive as the 23% . What’s the point here? Things are not always what they seem and just like the Cold Case Files, it’s time to pull out some of this information we’ve blindly believed and reexamine it.
First, of course, is the foundation. When relationships are muddy and too intermingled, it gives place for manipulated information. Right now there are so many ways that Wall Street can selectively control data, and because the government turns their head to much of it, the data that reaches the investor is questionable at best.
In my book, 401k Conspiracy, I cover the relationships and the head turning that goes on with the SEC and Congress, the approval of politicians and regulatory agencies, along with the dealings Wall Street has with data trackers like Morningstar, Lipper and other sources of information that are supposedly independent. Sources that investors rely on. Just looking at the fact that key data is allowed to be buried in a prospectus is enough to raise an eyebrow, but unfortunately, the rabbit hole goes much deeper than that.
Just take a look, for example, at the creative way poor performers are treated with Mutual Funds. When a poor performing fund is detected, it is promptly closed or merged out of existence. When this closure or merger takes place, the numbers that should be averaged into the overall performance of the fund disappear. It treats the poor performers as if they never existed which results in making the survivors and their category look much better than they actually are.
Do you realize how absolutely crazy this is? What if Tiger Woods had three or four bad shots in a row. There he is during a tournament. He doesn’t like the looks of this at all. Three bad shots in a row? Okay, okay….Here’s what we’ll do. We’ll cut to a commercial, rewind the footage of the three bad shots and take them out. Then, when we return from the commercial, we’ll pick it back up, but those shots won’t count. It will be as if they never happened. What? The crowd saw it happen! Well, anyone who doesn’t agree to ignore those bad shots will just have to leave. We’ll get rid of them too. Does this sound insane? It’s exactly what happens with poor performing funds every day. They disappear, but the smiling man on the advertisement and the mutual fund manager behind the desk pretend they never existed when they roll out the performance figures. And why should they? We all deserve do-overs and magical retakes don’t we?
Yes, it’s crazy. But it’s happening every single day. Sometimes I wonder if we all just fall into denial when things get that out of hand. We tell ourselves, “Oh certainly it can’t be that crazy! Who would allow that?” Kind of like the Trojan Horse theory. It’s so obvious and blatant, we just won’t see it.
1/3 of All Funds Become Cold Case Files
The A&E show also has a lot in common with a whopping one third of all funds that die and become cold cases. These losers and weak performers are killed off by the mutual fund company owners, then all records of their existence is destroyed.
Hiding evidence of wrong doing may be considered a criminal act in other realms, but with mutual funds there’s an immunity that needs to come to an end. Eventually it will, and I truly believe that one day another generation will look back in amazement at how gullible our generation chose to be. But for now, the survivor funds will continue to make the fund industry look far better than it actually is with their contrived averages.
Here’s how it works (in very simple terms). Let’s say you have eight funds in a category, and six are returning 10%, but the two losers are only returning 2%, then the average is 8 %. But if the losers get bumped off and their statistics are buried then you have six funds left. Now the average is 10%, much better.
How Badly is This Hurting the Average Investor?
In Survivor Bias & Improper Measurement: How the Mutual Fund Industry Inflates Actively Managed Fund Performance, a study published by Savant Capital/Zero Alpha Group, the question was asked, “Who is impacted when data providers publish biased returns?” The answer, was everyone.
Mutual fund companies often use peer group rankings (compiled of surviving peers) or compare their funds’ returns to the class average, and hopeful investors buy into these figures and convinced to invest in actively managed funds because the figures make certain managers look like financial superheroes.
This study concluded that survivorship bias systematically and significantly overstates the performance of actively managed mutual funds relative to their related indexes. Savant reported that actively managed funds in all nine of Morningstar style-box categories lagged their indexes. The study concluded that by purging the weakest funds they boosted apparent returns by an average 1.3% each year over the ten year period studied. That 1.3% might seem small, until you start compounding: For example, over the period (1995-2004) studied, the Mid Blend category returned a startling 72% less than shown in the database.
Survivorship bias, contrived numbers, head turning from the government and regulatory agencies, –all swept neatly under the rug.
So, what’s the bottom line? Well, in spite of numerous studies, like the example from Savant, and all the proof that this is going on, nothing is going to change quickly. Instead, it’s up to you, the investor, to be smarter than this game that’s being played at your expense.
Instead of actively managed funds and financial salespeople out to sell you products you don’t need, take control of your investment strategy. Create a well diversified portfolio, cut costs and fees, only deal with Registered Investment Advisory firms (fiduciaries), and you won’t have to worry about all the hiding, sweeping under the rug, and false numbers. We’ve opened the Cold Case Files and the misdeeds have been exposed. Now it’s up to you.