12/10/2013 06:39 pm ET Updated Feb 09, 2014

Dead Funds Walking... But Not Talking

Everyone is familiar with the SEC admonition that "past returns are not indicative of future results." Mutual funds are required to post that disclaimer on any document discussing past performance.

It's unfortunate that investors pay little heed to that admonition. That's exactly how the mutual fund industry likes it. It does everything it can to market the past performance of it stellar funds. This information can be extremely misleading, but it is very effective marketing.

One problem with relying on past performance is that you may not consider the risk taken by the fund manager to achieve returns. The risk taken by a manager of a fund that seeks to outperform the S&P 500 index is much lower than a fund manager of a small cap fund whose benchmark is the Russell 2000 index. A comparison of the returns of these two funds would be misleading unless you take into account their different risk profiles.

A much bigger problem is the number of "dead" funds. A comprehensive study by Vanguard looked at the performance of mutual funds that closed over a 15 year period ending 2011.

It found poor performance and a lack of commercial success were the primary reasons why funds "died." Typically, the performance of "dead" funds is not included in performance databases, leading to returns data that can be misleading.

For example, for the five years ending December 31, 2011, standard databases reported that 62 percent of large-cap funds outperformed their style benchmark. If this data had included "dead" funds, the percentage was reduced to 46 percent. That is a meaningful difference.

Significantly, Vanguard found that only 54 percent of the 5,108 funds in its sample survived the full 15 year period. Those that didn't were liquidated or merged. Investors who picked a fund on January 1, 1997 that survived, had a 22 percent chance of selecting an outperforming fund, but they had a 79 percent chance of picking a fund that would underperform, be liquidated or have a life cycle too convoluted for the study to untangle.

The study concludes that the failure to include "dead" funds "can artificially inflate performance." It recommends investors who are looking at performance numbers take into account "dead" funds.

Ironically, whether or not dead funds are included begs a critical, underlying issue: Why are you engaged in the process of trying to select an outperforming actively managed fund? Remember,investors in this study had only a 22 percent chance of picking a fund that survived and outperformed (or was merged and ended up outperforming) over the period studied. Those are pretty dismal odds.

Here are some questions to ask your broker the next time he recommends an actively managed fund, using past performance data:

1. If the SEC states that past performance is not indicative of future results, why should I pay attention to past performance?

2. What are the chances you can select a fund that will survive over the long term, much less outperform?

3. What are the chances the fund you select will outperform its benchmark over the long term?

4. Does the data you are providing include or exclude the performance of "dead" funds?

If you receive honest responses to these inquiries, you may conclude you would be better served investing in a globally diversified portfolio of low management fee index funds.

Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His next book, The Smartest Sales Book You'll Ever Read, will be published March 3, 2014.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.