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Index Funds Are Even Better Than You Think

'Survivorship bias': What it is and how it's important to your nest egg

mutual fund rankings

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When stacking up retirement investments and weighing your options, take a closer look at index funds.

You've probably heard that index funds beat the vast majority of active mutual funds over the long term. Though that's completely true, they do so by even more than is typically reported. That's because the average long-term performance of any group of funds includes only those funds that survived over that period. It doesn't count the funds that were shut down by their managers for poor performance or other reasons. So the average performance is enhanced by counting only the survivors.

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Using the Vanguard 500 Index Fund Admiral Shares as an example, and some data from Chicago-based research company Morningstar, here's the bottom line over the past 10 years.

According to Morningstar, the index fund earned an average 6.3 percent annually over the 10 years ending Feb. 18, 2016. This was compared to similar domestic stock mutual funds investing in large companies (large cap) with a combination of value and growth stocks (blend). According to Morningstar, the index fund beat 82 percent of the 878 other mutual funds in the category that have been around at least 10 years.

The average return of all 879 mutual funds was 5.36 percent annually, so this index fund earned 0.94 percent annually above the entire peer group. That may not sound like much, but on a $10,000 investment, that's an extra $1,566 over the 10 years.

Yet, as previously mentioned, it did even better than it would seem. Each year many mutual funds go out of business, and those typically are the poorest of the performers. The peer group of 879 funds comprises only those that survived over the 10-year period.

I asked Morningstar to calculate the return of the entire peer group, including those funds that went out of business. According to Morningstar, roughly 363 mutual funds in the category went out of business during that 10-year period. Had those funds been included in the peer group, the average annualized return would have been only 4.92 percent.

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This means that the index fund beat the entire group of funds, including those that went belly-up, by 1.38 percent annually. Thus the impact of the survivorship bias is estimated to add another 0.44 percent annually. So, including survivorship bias, this index fund earned $2,257 more than its peer group over the 10 years, for each $10,000 initially invested.

So the next time you see an ad touting the average performance of a category of mutual funds, keep in mind that it does not include the ones that failed.

What this means for you

None of us can say with certainty which stock funds will shut down over the next decade. I suspect that some will be among those that beat the index fund over the past decade. Yet, as they say, past performance is not indicative of future performance.

It's important to remember that the higher the fees you pay, the lower the odds are of beating the index fund. So, if you believe you need the money you earned and saved more than Wall Street does, consider broad index funds. And when you look at how they have done versus their peer group, remember that they have done even better if you take into account survivorship bias.

Allan Roth is the founder of Wealth Logic, an hourly based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.

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