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Why you should be suspicious of funds' returns

Norman Rothery is the value investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

I'm looking forward to watching the rest of the Winter Olympics. Win or lose, the skill and dedication of the participants are proving to be extraordinary.

To win the gold requires a huge amount of effort over many years. But it's easy to overlook the people who tried to reach for the top and failed. As in many fields, failure is a real probability even for those who put in enough effort to stand a chance.

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Focusing solely on the winners can lead to a dangerously skewed view of the world. It's a particularly acute problem in the markets, where luck often plays an important role.

Problem is, the market tends to bury its failures, which slip out of both sight and mind. Investors who don't account for them may find their decisions swayed by survivorship bias. It's a factor that fund investors should be particularly wary of.

To see why, it's important to remember that fund managers are in the business of accumulating assets. After all, they typically get paid based on how much they manage.

As a result, the pressure is on to attract as much money as possible and there is little better for such efforts than a stellar performance record. A strong record draws assets from investors like moths to a flame.

But investors who simply seek out good past performers run the risk of ignoring how those returns were generated. Extraordinary short-term returns are usually the result of a large bet that happened to pay off. It's why the list of top performers is usually dominated by focused funds that concentrate on a particular industry, country, or only a few stocks.

Some fund firms deal with the role of luck rather directly. They shut down funds with poor records. It's a strategy that leaves the winners alive and leads to pleasant marketing material, but it also represents survivorship bias in action.

Hedge funds have a particularly bad reputation for closing down after a bad run. Some do so to get a second shot at earning performance fees. Think of it this way: If a portfolio manager rolls the dice on a risky strategy and wins, then they get a big payday. If they lose, the fund can be closed down and the game started all over again.

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It's important to be more than a little suspicious of average fund returns that haven't been properly corrected to account for survivorship bias.

If the foregoing makes you inclined to throw up your hands and opt for low-fee, broad-based index funds, you're in good company. Renowned investor Warren Buffett thinks that regular investors should take exactly such an approach.

As it happens, Mr. Buffett made a wager six years ago with asset manager Protégé Partners, which bet him that they could beat the S&P 500 with five hedge fund picks over the following decade. The winner will be decided in four years and the loser will pay at least a million dollars to charity.

So far, the S&P 500 is in the lead with gains of 44 per cent. The hedge fund portfolio is up only about 13 per cent.

That's not to say the funds won't win in the end because a great deal can happen in the remaining four years. After all, a big market crash could reverse the standings. But over the long term, it's hard to beat the market using high-fee funds.

When money is on the line, the results can't be skewed by a little revisionist history. It's something to remember when shopping for funds. If you don't take care, what looks like a gold medal winner could prove to be nothing more than a mirage.

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