Wall Street WARZONE

“Numbers Game:” How Wall Street “Croupiers” Fudge Stats, Fix the Odds, Mark the Cards & Skim $200 Billion in Profits From $12 Trillion of Your Mutual Funds

by Paul B Farrell, JD, PhD
| | 4/11/2010

There are so many clever ways Wall Street can selectively manipulate and control the data available to investors, with the direct or indirect help of the SEC and Congress: In the timing and disclosure requirements in advertisements; burying key data in a prospectus; using information that is outdated, often three months to a year or more old, for example. Wall Street also has many dealings with data trackers like Morningstar, Lipper, Moody’s, Standard & Poor’s and others supposedly independent suppliers of data investor rely on. Wall Street not only buys data from these sources, they often use their related subsidiaries to do marketing research. Cozy relationships with so-called “independent” data sources supplying data to Main Street investors get the tacit approval of politicians, regulatory agencies, private industry and the media and offer many opportunities for data manipulation.

For example, when a poor performing fund is closed or merged out of existence, its statistics also disappear, that makes the survivors and their category look better than they are. Halloween’s my wife’s favorite holiday, the biggest of the year around our house. We start early. Suddenly, right after Labor Day, vampires, ghosts, witches, black cats, mummies and zombies return from the underworld to haunt us, purge our darkside. They take over the house. Just lotsa statues, icons, scenes, cobwebs. Okay, so there’s a kid in all of us. We even have a one of the entire Peanuts gang waiting for the immortal “Great Pumpkin” to arise once again from the patch.

Night of the Living Dead haunts $12 trillion of your money

Halloween, the Night of The Living Dead, is also a great metaphor for the darkside of America’s $12 trillion mutual fund industry, a time to descend into the gory cemetery of long-dead funds. This frightening tale paralyzes investors, forcing us to bury our fears deep in the dungeons of our brains. Investors are blind to the fact that historically as many as one third of all funds “die” and become cold cases. The losers, the weak ones, the low-performers are systematically exterminated by assassins, yes, actually killed off by their own parents, the fund company’s owners. Then, all records of their deaths and autopsies are expunged from databases, as if they never existed. It is an ancient story that rivals the best horror films, Friday the 13th, Scream and Halloween.

But theirs is sweet revenge. The dead come back to haunt the living, the survivors. Nothing’s sacred in the financial world. Not even the cold, hard statistics from those saintly mortals at Lipper and Morningstar. When funds die, sadly, those “saints” bury them. But then, in an act of revenge, like true vampires, ghouls and zombies, they return from the dead, coming back to haunt us, not just on Halloween, but all year long, every year, for all eternity.

Losers buried in unmarked graves

The script’s right out of Tales of The Crypt. Hiding evidence of wrong-doing may be criminal in the eyes of law. But in the monstrous mausoleums of mutual funds, the “evildoers” get away with it. They have immunity with the law. Survivor funds live on, making the fund industry look better than it otherwise would. Get it? These vampires actually suck the blood out of the averages Wall Street sends to you—making them appear lots better than they really are. For example: If you have six funds in a category, and five are returning 10%, but the one loser is returning only 1%, then the average is 8.5%. But if the loser gets a Soprano whack-job and its statistics are buried anonymously in a concrete vault off the end of the pier, then you have only five funds left. And as if by black magic, the peer average of the five “survivors” is now 10%, not 8.5%!

So how bad is it? How much is it hurting the living?

In a study published by Savant Capital/Zero Alpha Group, Survivor Bias & Improper Measurement: How the Mutual Fund Industry Inflates Actively Managed Fund Performance, they ask: “Who is impacted when data providers publish biased returns? Everyone: Mutual fund companies often compare their funds’ returns to the class average or use peer group rankings (of only surviving peers). And investors often buy actively managed funds on the premise that managers in certain categories appear to add value (prior to adjusting for survivor bias). Investors assume that the average manager in such biased categories must deliver better than index returns based on inaccurate peer (category) group returns. Of course, they buy such active managers under the presumption that such funds will do better than average in the future.”

Warning, so-called “independent” data-trackers are at war too

This study concluded that survivorship bias exists in 41 of 42 categories over a 10-year period, and “is cumulative in nature, becoming more pronounced as time passes.” Moreover, it “is not as insignificant as Morningstar would like us to believe,” but has “the effect of systematically and significantly overstating the performance of actively managed mutual funds relative to their related indexes.” Savant says the actively managed funds in all nine of Morningstar style-box categories lagged their indexes. And by “purging the weakest funds [they] boosted apparent returns by an average 1.3% per year over the 10-year period.” A little 1.3% may not seem like much, until you start compounding: “For example, over the 10-year period (1995-2004) studied, the Mid Blend category returned a whopping 72% less” than shown in the database. “The largest evidence of survivor bias exists in the Aggressive Growth Fund category at 116%!”

Yes, dead live on and on, haunting Main Street’s future

Their bottom line is very simple: “When the class average is overstated, the public makes buying decisions on a false premise. Investors are duped. Mutual fund companies promoting active management gain assets (and income) by remaining silent on the matter. Data providers publish incomplete data. No one is left unscathed.” Within weeks, Morningstar took issue with the accusation that they have “blinders on.” And the truth is, they aren’t hiding anything. They’ve openly discussed the impact of survivor bias many times. They say there’s “absolutely no evidence that survivorship bias has prompted investors to shy away from index funds,” citing the success of Vanguard’s index funds.

Over the years survivor-bias has been hotly debated going back to the nineties. Princeton’s Burton Malkiel, author of A Random Walk Down Wall Street, published his research in the Journal of Finance: “Ghosts of Dead Funds May Haunt Results.” And Jason Zweig wrote in Money magazine: “The Truth About Zombie Funds.” Looking back over the prior three decades they noted:

· Huge graveyard: Out of 2,071 equity funds, over one third (725) were killed off between 1962 and 1995. Dig the vampires out of the graves and the average category returns sink 1.3% below their indexes.
· Big risks: A higher percentage of Aggressive Growth funds were buried, about 40% (242 of 614). Resurrect them and their 13.5% returns drop to 11.6%; just one percent higher than the S&P 500, and only slightly higher than 10.4% from less risky Growth funds.
· Higher expenses: Operating expenses of the 725 vampires were 33% above the average. And during the final five years before burial, they under-performed surviving relatives by 20%, while many naïve investors remained painfully loyal to those funds through their slow, agonizing funeral procession.

Even back then Morningstar was analyzing the terrible truth: “What this means to you is that past performance comparisons won’t tell you everything you need to know about a fund. It’s a sad fact, but numbers do lie.” So please, never forget that truth, or you too will be buried in an unmarked grave along with the vampires, zombies and ghouls.

“Script” never changes—next time, new stats, new characters, same plots

Here’s our bottom line: In spite all the shouting by Malkiel, Zweig, Savant, and all the other indignant researchers, the harsh truth is … nothing’s ever going to change! So stop fighting city hall. It’s a waste of your time, money and energy. In spite of all the rumors of dark-side secrets, greed and corruption in the mutual fund industry, America’s 95 million investors are doomed to live with survivorship bias, for all eternity … or until Morningstar removes survivor-bias from their database, which they tell me they’re in the process of correcting.

Meanwhile, you can beat the system. Yes! How? Stop play their game by their rules! Forget about all their actively-managed funds. You never have to buy one, never! Remember, only one actively-managed fund has ever beat the S&P 500 over the long-term. Instead, quietly create a well-diversified portfolio of low-cost, no-load index funds. That way, dead funds can’t come back to haunt you ever again. And you’ll live in peace—even near a cemetery!

Index funds are the only living survivors who are real, immortal and strong enough to face the evil ones. The rest belong as extras in films like Night of the Living Dead, Friday the 13th, Scream and Halloween. Go index: You’ll have no fear of the blood being drained out of your retirement portfolio by vampires, ghosts, witches, ghouls, zombies … and fat cats!

FirstPubDate: Oct’06

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