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Managers’ selection: Survivors always look better, whether they are skilled or not

By Dominic Clermont, ASA, MBA, CFA - ClermontAlpha.com
February 7, 2012

Survivorship bias is present and part of our due diligence process. Whether a manager’s performance database is “free of survivorship bias” or not, the typical use of the database by investors and consultants induce such effect and may lead them to improper conclusions and decisions. The impact of survivorship bias is much greater for low-skilled managers making it virtually impossible to distinguish between skilled and non-skilled “surviving” managers based solely on performance. Survivorship bias also has a much greater impact on high risk investment strategies, something to keep in mind when considering highly concentrated portfolios. Finally, survivorship bias may induce positive correlation between value added and active risk, even when there is no correlation (i.e. for non-skilled managers).

While I was heading a risk-controlled active group at a leading bank, one of my competitors, working for a subsidiary of a leading global manager, developed a competing product which was sold as a quantitative strategy with a judgmental overlay. Their marketing (which included their parent clout) was very successful at attracting clients. Unfortunately for their clients, the performance was very negative leading the fund to have the worst performance (last percentile ranking in a leading managers’ survey) over 3, 4 and 5 years. All clients exited the underperforming strategy and the investment team was dismantled. I tried to obtain its historical performance from a survey prepared by one of the largest global investment consulting firm who pride themselves of having a database of managers with no survivorship bias; unfortunately they did not have any data on this defunct fund anymore.

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we should not be afraid of concentrated/more risky portfolios. the information ratio of the average manager is a spectacular 0. The effect of survivorship bias is much more important than investors think! Investors and consultants do not fully appreciate the difficulty of differentiating skilled and nonskilled managers. Another investment consulting firm is recommending a more active management approach at a much higher risk based on the following analysis: Exhibit 1: Active Return vs Active Risk for Global Mandates The analysis refers to global mandates and a global benchmark. The impact of surviving (and/or screening the underperforming) can easily be illustrated in a simple scenario where we would screen out managers with negative active (excess) returns. the above observations are suspicious. From the chart in exhibit 1. and active risk of 1%.63 is clearly significant and means that for every increase of 1% in risk for the average manager. we can also observe many managers with an IR of around 1. Since return increases with risk.63%.63. There is a strong correlation between active return and active risk. the distribution of active returns would look like this: 2 . The slope of 0.Survivorship bias is responsible for a significant positive drag effect in managers’ performance survey. Their observations and recommendations are:    There is significant value added from global mandates. The managers that investors and consultants meet are those who have survived till today. In other words. While global markets generally offer a better risk-return profile due to their lower efficiency. value added increases by 0. If we simulate a large numbers of unskilled managers with expected active returns of 0%.

The lucky non-skilled managers would have a median outperformance of 0.67% and an average return of 3. 3 .20%.80%.67% and an average outperformance of 0. we are left with the lucky ones.Exhibit 2: Return distribution with Expected Active Return of 0% (no skill) & Active Risk of 1% If we screen out the underperforming managers. we could redo the above simulation at say 4% active risk and we would obtain the same numbers as above multiplied by 4. By eliminating those non-skilled managers who experienced negative returns. a median excess return of 2.e. For a typical level of active risk. i. we obtained the following truncated distribution: Exhibit 3: Truncated Return distribution with Expected Active Return of 0% (no skill) & Active Risk of 1% with negative returns eliminated This distribution would be observable for managers with no skills (expected returns = 0%) and one percent active risk.

We can only hope that a manager with some positive investment skill will manage to maintain that skill and deliver some consistent IR. we may tolerate some small negative performance (which is why my former competitor lasted for more than 5 years with bad performance). 10-year simulation In practice. managers do not get screened-out after only one year of negative performance. 4 . Unfortunately.In fact. I did two sets of simulation for two level of ex-ante IR:     IR of 0 (non-skilled managers) and IR of 0. i. We generally ask for three years of returns.8 – a performance quite exceptional! Every investor and consultant would love to know for each of their managers their “true Ex-ante IR”. their median Information Ratio over one year is 0. In our simulation.3 (skilled managers) Active risk from 1% to 14% Threshold before firing the manager: 3-year rolling outperformance of below -2% Simulated returns are log-returns in order not to generate any negative bias in compounded returns.e.67 and their average IR is expected to be 0. this measure is unknown. We can only measure a manager’s “Ex-post IR” over a period of historical time which is more or less long depending on the manager. the IR we can expect from that manager if we invest with him over a long period of time. it is not static as the manager changes and the economy changes. For large established firms. for no-skilled managers with positive return by chance. we assume that we know the Ex-ante IR (and that it is fixed over time) and look at the impact of screenings and manager’s disappearance on the Ex-post/observed IR. Even if the Ex-ante IR would be known.

10-year simulation . If this chart looks familiar. independent of how large the expost/observed value added is.IR of 0 (non-skilled managers) Exhibit 4: 10-year simulation for IR of 0 (non-skilled managers) As expected. We obtain the following chart. all these simulated managers have the same ex-ante expected value added of 0% . it is 5 . the average simulated IR is 0. Some were very lucky with high alpha and high ex-post IR. independent of the active risk level. The volatility of the annualized return should be: √ This is why we observe a dispersion of performance around the expected value added of 0% which increases with risk. The average expected value added is 0 as expected. thay all have no skill. The trend line has a slope of 0 meaning no value added for the average manager. while those below the zero line were unlucky managers with negative alpha and negative ex-post IR. It is important to note that. All managers above the zero line were lucky managers with positive alpha and positive ex-post IR.e.i. we end up keeping all lucky managers having all of their overlapping 3-year return above -2% during the 10 year of the simulation. If we screen out any manager with a negative 3-year rolling outperformance below -2%.

because it is very much alike exhibit 1 from a real managers’ database. Suddenly our surviving non-skilled managers look like they are skilled! Exhibit 5: 10-year simulation for IR of 0 (non-skilled managers) keeping only the “survivors” 6 .

even after 10 years. Exhibit 6: 10-year simulation for IR of 0. In fact. If we screen out any unlucky skilled manager with a negative 3-year rolling outperformance below -2%. and show negative value added over the whole period. We obtain the following chart: 7 . many of them are unlucky. this time assuming an IR of 0.3. Note that while all these simulated managers have the same investment skill. we end up keeping all managers having all of their overlapping 3-year value added above -2% during the 10 year of the simulation.10-year simulation . No clients would tolerate their skilled managers to underperform for 10 years. thus the same expected value added per unit of active risk. the slope of the trend line is close to 0. everyone would wrongly classify them as non-skilled.30 (skilled managers) For all simulated managers.3 (skilled managers) We redo the same exercise.IR of 0.3 (t-stat above 13) showing a clear investment skill for this group of managers.

3 to an observed 0. IR increases from an expected 0.61.30 (skilled managers) keeping only the “survivors” As for the non-skilled managers.51.0 to an observed 0. the skilled survivors see their average IR improve but the impact is less significant as the average IR increases from an expected 0. 8 .Exhibit 7: 10-year simulation for IR of 0. For no-skilled managers.

Exhibit 8: 10-year simulation with both skilled and non-skilled managers . as the noskilled manager looks almost as good as the skilled one.keeping only the “survivors” The screening process has a much greater positive impact on the non-skilled manager’s IR. When we apply a realistic screening process as in the simulation above. We also observe a negative relationship between survival rate and active risk. While the no-skilled managers have a higher “death” rate compared to the skilled ones. we obtain a graph showing how difficult it is to distinguish between a skilled manager and a non-skilled one.10-year simulation – Combining both simulations: Ex-ante IR of 0 and 0. 9 . the conclusion of this exercise is that we can’t base our decision on performance.3 If we combine both groups (after screening). a higher survival rate for skilled managers vs lower-skilled ones. Survival Rate The above analysis would not be complete without talking about survival rate. This means that the “death rate” increases with risk whether a manager is skilled or not – something to keep in mind when contemplating highly concentrated strategies. we observe. as expected.

43% of the low risk managers have been lucky enough to still be there after 10 years. Since dead funds generally had poor returns before ceasing to report. stock funds had delivered an average 1986 return of 13. there are really three: 1.S.0. Types of Survivorship Bias While the literature document two types of survivorship bias. 10 years later. In 1986. merged or otherwise dissolved funds. excluding their history from the database cause the reported performance in those years to overstate the true average return available to investors at the time. Lipper 10 .3. while this survival rate drops to slightly less than 10% for the higher risk ones – an incredible performance for managers with expected value added of 0. 568 diversified U. Damato [1997] report a mutual fund performance by Lipper Analytics.Exhibit 9: Survival rate after 10-year simulation keeping managers with rolling 3-year return above -2% For the skilled managers with an ex-ante IR of 0. This effect is relatively well researched and documented in the literature.39%. For the nonskilled managers with an ex-ante IR of 0. Survivorship bias – Past return of managers who ceased reporting This bias occurs when a managers’ database exclude all or part of the returns of dead. one third of the low risk managers have disappeared after 10 years and over 70% of the skilled high risk managers are gone.

As we will see in a moment. it does not eliminate all survivorship bias effects.19% 8% 4.20% to 1. if not eliminate.47% 1. as asking for my defunct competitor’s historical performance showed. Some database providers now market their product as free of survivorship bias.81% 3.50% 2.3 have expected value added of 1.20 IR=0.11% 0.provided a different picture of the same 1986 performance as there were only 434 funds remaining with an average return of 14. this impact of survivorship bias in reporting historical average performance by all managers. is that this assertion is not always valid.50 1. This leads to overstatement of the backfill period average managers’ performance as funds would generally be added after good starting value added. Reported value added for year 1 increases by approximately 0.00 IR=0. typical usage by investors and consultants do create subsamples that do have survivorship bias.73% 0. 2.20% (IR of 0. Reported performance increases significantly when eliminating underperformers and looking only at survivors.31% 0.53%) at the end of year 3 when we screen out underperforming managers. Investors will typically focus on managers with positive track records.33% 0. And that increase is higher for lower skilled managers and for managers taking higher active risk.33% (from 1.78% 1. I obtained the following interesting statistics: ACTIVE RISK 4% IR=-0.30 times 4% active risk).65%. Furthermore. Backfill bias or Instant History Bias Backfill bias occurs when a database supplier backfill a new fund’s performance when added to its database. Using my simple rolling 3-year screen described previously. 11 .80% Exhibit 10: Year 1 performance improvement when applying the rolling 3-year screen (deleting funds with performance below -2% at the end of year 3) The interpretation of this table is as follow: Skilled managers with an IR of 0. Database which keeps the historical track record of defunct funds reduce.50 IR=-0.30 IR=0. My own experience.

To be totally clear of such survivorship bias effect. observed between value added and active risk.3) with an observed average IR of 0. its use often involves significant survivorship effect. Investment in more concentrated portfolios should be based on true measure of an investor’s investment skill.80 . 3. Survivorship bias – screening the database Even if the managers’ database is free of survivorship bias. Investors and consultants should be reminded that the IR of survivors often overstates their true ability. Even if database providers keep dead funds’ historical performance. the database would need to include the performance of funds even after they have stopped reporting – something not possible for dead funds. survivorship bias is still present (and neglected) in the use of the database. The positive correlation. The survivorship bias effect has much greater impact on low-skilled managers making it virtually impossible to distinguish between skilled and non-skilled managers based only on historical performance. This is probably wrong as the historical performance belongs to these firms.62% of the skilled managers (IR=0. When considering investment managers. these one-year positive new-comers would include: . defunct funds are evidently eliminated. again. inducing a survivorship bias effect – something that was documented by Cathcart [1994]. The fact that database suppliers keep defunct funds in the database for the period they were managing money does not cancel the survivorship bias faced by hiring investors and their consultant in their use of such database. When reporting the average return for that period. The survivorship bias effect increases with active risk and.92 Some firms try to eliminate the backfill bias effect by eliminating the historical performance of newcomers. IR is not a measure of skill and is only weakly correlated to 12 . leads some investors and consultant to seek more concentrated portfolios. 5 or 10 years. Conclusion Survivorship bias in manager’s database may come from the database maintenance which does not keep historical information of funds that ceased reporting. Such screening process has exactly the same effect as the one described in this paper. investors and consultants screen for managers with a certain positive historical performance over 3. may induce false correlation between value added and active risk for nonskilled managers. Its effect is to induce and/or increase the correlation between value added and active risk – even for non-skilled managers (IR of 0). backfilled data should be excluded to take into account that new managers with negative first year performance most likely did not report. If we screen the database for all managers with a 10 year history.If only the managers with positive first-year value added were accepted to report to the database.50% of the non-skilled managers (IR=0) with an observed average IR of 0.

Mark Carhart. By KAREN DAMATO. Wall Street Journal. April 4. not luck. it takes more than 40 years. 1997 13 . Information Coefficient (IC) is generally seen as a more proper measure of an investment skill but requires a lot more information and analysis by investors and consultants.skill in the long run.30. “Mutual Fund Survivorship”. We could still be wrong 5% of the time! With managers with an IR of 0. doctoral dissertation.5 delivered value added from skill.If Included”. 1994 “Dead-and-Buried Funds Would Alter 'Averages' . And these observed IR are those of survivors – thus they generally overstate their true IR. Investors should keep in mind that it takes 16 years to be 95% confident that a manager with an IR of 0.