Fooled by the Winners

How Survivor Bias Deceives Us

David Lockwood

• Publisher: Greenleaf Book Group
• Year: 2021
• Print ISBN: 9781626348806
• eBook ISBN: 9781626348813
• Topic: Social Sciences
• Subtopic: Social Science Research & Methodology
• Index: Social Sciences

Fooled by the Winners will change the way you think about the stock market, health care, global warming, diets, lotteries, restaurants, and your siblings. It will reshape your perspective of the past and give you a clearer view of the future. Fooled by the Winners is a book about survivor bias, the cognitive error of focusing on the winners, the successes, and the living. But in many instances, we can learn more from those who have lost, failed, or died. After reading this book, you will understand how survivor bias is often used to deceive us. You will learn how to stop paying for financial services that promise more than they deliver, for health care that doesn't make us healthier, for diets that don't make us slimmer, and for advice books that don't offer good advice. You will also come away with a different view of our past, including our perilous evolutionary journey and how history has often been written by the winners. You will come to understand how we are fooled by the winners in warfare, such as in the deployment of nuclear weapons and the most famous example of survivor bias—the missing Allied bombers of WWII. Previous studies of survivor bias have been inaccessible to most, housed in formula-laden statistical journals. But you won't find any math or technical jargon here. David Lockwood, a former member of the faculty of the Graduate School of Business at Stanford University, applies the concept of survivor bias to specific, real-world examples—minus the equations. Through compelling analysis and the real-life stories, this book demonstrates the deceptive influence of survivor bias in our daily lives and on our thinking.

PART I

CHAPTER 1

Financial Services:
So Much for So Little

Fred Schwed and Customer Yachts

Fred Schwed (1902–1966) was, in the terminology of his day, “a customer’s man.” For almost two decades, he worked for the Wall Street firm of Edwin Wolff, hawking stocks to retail investors. Today, he would be called a registered representative, or more commonly a stockbroker. In his spare time, he wrote books, including a popular children’s novel, Wacky, the Small Boy, a best-seller during the 1930s.

Schwed was the son of a member of the New York Curb Exchange, later renamed the New York Stock Exchange. In 1924, after graduating from Columbia University, he went to work on Wall Street. The 1920s was a period of rampant speculation, when the allure of a booming market and cheap margin debt seduced millions of individuals to place their life’s savings into stocks. After the equity markets crashed in 1929, Wall Street and the nation were plunged into a depression that lasted until WWII. In fact, the Dow Jones Industrial Average (DJIA) did not return to its 1929 height in absolute terms until 1958. So, during the many years he worked on Wall Street, Schwed experienced the best and worst of times.

Schwed developed a keen eye for the foibles and follies of his colleagues and shaped his observations into pithy anecdotes. In 1940, he cast his thoughts into a humorous and insightful short book entitled Where Are the Customers’ Yachts? or A Good Hard Look at Wall Street.¹ The title of Schwed’s book comes from his observation that Wall Street is a more profitable place to work than to invest.

Schwed wrote:

Once in the dear dead days beyond recall, an out-of-town visitor was being shown the wonders of the New York financial district. When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor. He said,

“Look, those are the bankers’ and brokers’ yachts.”

“Where are the customers’ yachts?” asked the naïve visitor.²

Today, the financial services industry continues to be a lucrative place to earn a living. In Schwed’s words, “Wall Street is the highest paying spot on the face of the Earth.”³ The financial sector of the US economy employs fewer than 5 percent of all US workers yet claims almost 30 percent of all corporate profits.⁴

The financial sector is extraordinarily profitable due to the economics of its primary business: managing the savings and investments of the nation, or what is known as asset management. For US securities firms, asset management is critically important, accounting for just over half of total revenue.⁵

The asset management business is extraordinarily profitable partly because of the way it charges investors. Unlike many other service industries, most financial services professionals are paid on a percentage basis. By contrast, lawyers bill per hour, regardless of the size of the transaction. This makes sense: The cost of a lawyer’s time is the same whether the deal to be negotiated is for $100 million or $1 million. But charging a percentage of assets under management is the most common fee arrangement for fund managers. For instance, hedge funds typically collect fees of 1 to 2 percent of assets under management and 20 percent of all investment gains. Hence, a hedge fund manager charges one hundred times more for investing $100 million than $1 million. The same applies to wealth advisors and mutual fund managers, who generally charge a fee based on a percentage of assets.

The exceptional profitability of the asset management business is reflected in employee compensation. The average mutual fund portfolio manager earns about $1.3 million in salary and bonuses.⁶ At a hedge fund, that number is $1.4 million.⁷ Those at the very top of the US hedge fund industry are paid even more. In 2017, the twenty-five highest compensated hedge fund managers were paid an average of $615 million each.⁸ Assuming a 250-day work year and ten-hour days, that equates to $246,000 per hour. In the United States, the average worker earns an hourly wage of $27.⁹ These unusual levels of compensation can make headlines: A prominent hedge fund manager was reported to have purchased a second home in New York for $250 million. No similar purchases are known to have been made by his investors.

The justification for the extraordinary amounts of money paid to hedge fund managers is that they outperform the market indexes. There would be no reason to pay a hedge fund manager to match market returns; an index fund achieves that result without the exorbitant fees. To convince investors to pay these fees, hedge fund managers offer “proof” of their ability to generate returns in excess of market benchmarks. But the proof put forward is riddled with survivor bias. Schwed warned us of this in 1940.

He wrote:

Figures, as used in financial argument, seem to have the bad habit of expressing a small part of the truth forcibly, and neglecting the other part, as do some people we know.¹⁰

John Meriwether and LTCM

John Meriwether is an example of how the failure to adjust for survivor bias benefits hedge fund managers.¹¹

Meriweather grew up in Chicago and from an early age was an avid gambler. As a teenager, he bet on horses, blackjack, baseball, and golf, a sport in which he excelled. He graduated from Northwestern University, taught high school math for a year, and then went to the University of Chicago, earning an MBA in 1973. He was hired by Salomon Brothers after business school and joined the fledging fixed income department. In 1977, he founded the arbitrage group within Salomon Brothers. The name was apt. Rather than betting on the absolute price change in a security, Meriwether specialized in betting on the change in the relative price difference between two fixed income instruments, or what is known as bond arbitrage.

In the late 1970s and 1980s the arbitrage group at Salomon Brothers enjoyed a number of successful years and generated a substantial portion of the firm’s profits. Meriwether soon climbed to one of the top rungs of the Salomon Brothers’ corporate ladder. However, in 1991, Meriwether and his arbitrage group submitted a series of false bids to the US Treasury in order to gain a disproportionate share of newly issued securities. The resulting crisis almost bankrupted the brokerage firm.

To restore faith in the firm, Warren Buffett stepped in as CEO and Meriwether resigned, although Meriwether defended his actions and those of the arbitrage group to the very end. The SEC charged Meriwether with the civil crime of failing to supervise his employees, and he settled with the SEC, agreeing to a three-month suspension from the securities business and a $10,000 fine. After he left, Salomon Brothers recovered, and the firm was sold to Citigroup in 1997.

After departing Salomon, Meriwether founded Long Term Capital Management (LTCM). His pitch to investors was that he would undertake the same arbitrage strategies at LTCM that had proven successful at Salomon Brothers. He also recruited a number of leading academics and brought many of his former colleagues from Salomon Brothers to the new hedge fund. Some were surprised that Meriwether, after being fined and suspended from the securities business by the SEC and almost bankrupting his firm, could raise monies from investors. However, he persuaded enough individual and institutional investors to trust him with their savings to open his new fund in 1994 with over $1 billion in capital. (He pitched Warren Buffett to invest, but Buffett declined.)

From 1994 to 1997, the returns on investor capital at LTCM substantially exceeded the market indexes, and the firm steadily grew in size. By the early months of 1998, total capital under management had risen to $4.7 billion.

And then it all went pear-shaped.

During 1998, the Asian financial crisis weighed heavily on the debt and other financial markets. Returns for LTCM turned sharply negative in May of that year and continued to be negative throughout the summer months. In August, Russia declared a debt moratorium, effectively suspending payment on Russian-issued government bonds, sending emerging market debt into a tailspin. Investors around the world fled to the safety of more liquid, higher rated securities. By the end of August, LTCM had lost almost $2 billion in capital.

LTCM lost money primarily because the firm had been betting that the spread would narrow between higher rated, more liquid securities and those with a lower rating and less liquidity. From the founding of LTCM in 1994 to 1997, LTCM’s bet paid off as the difference in price between these two groups of securities had steadily declined. However, during times of crisis, investors flee to the security of higher rated and more liquid securities. The summer of 1998 was no exception, and the spread between these two groups of securities significantly widened. By September, LTCM had lost another $2 billion and was insolvent.

In response, the Federal Reserve Bank of New York took control of LTCM from Meriwether and liquidated most of his investments. LTCM investors were almost entirely wiped out, and the banks that had lent money to the firm incurred substantial losses. LTCM’s largest creditor, UBS, lost $780 million, and its chairman was forced to resign.

Not surprisingly, LTCM did not report results to the hedge fund indexes for 1998. If LTCM had reported results, investor returns would have been a negative 91 percent for that year.¹² During the period in which the firm was part of the hedge fund indexes, from 1994 to 1997, LTCM reported that investors gained an average of 32 percent per year.¹³ However, from 1994 to 1998, including returns from that last nonreporting year, LTCM lost investors an average of 27 percent per year.¹⁴ From 1994 to 1997, the returns of LTCM were included in the major hedge fund indexes. Once LTCM closed up shop, performance of the fund was deleted from the historical returns of those indexes.

Survivor Bias and Hedge Fund Performance

LTCM is an example of how investors evaluating the performance of hedge funds as an asset class can draw the wrong conclusions due to survivor bias. The returns reported by a hedge fund index contain only the past performance of the surviving funds. The non-survivors, such as LTCM, are excluded from the indexes. A hedge fund index should really be called an “Index of Not-Failed Hedge Funds.”

Hence, due to survivor bias, hedge fund indexes overstate the performance of hedge funds as an asset class. This is particularly true because the rate of hedge fund failure is high. If only a small percentage of funds ceased operations each year, the effect of survivor bias on hedge fund indexes would be minimal. But this has not been the case.

In a study of 720 hedge funds that started twenty years ago, only 262 were still operating after the first decade, and only 13 after the second.¹⁵ Another study of over one thousand hedge funds showed that from 2004 to 2014, fewer than half that started at the beginning of the period were still in business ten years later.¹⁶ As expected, the number of hedge fund closures varies with market conditions. One survey showed 16 percent of hedge funds had dissolved in 2007, but that number increased to 31 percent in 2008 during the financial crisis.¹⁷

And not all hedge fund closures are involuntary. The compensation structure of hedge funds provides an incentive for a hedge fund manager to close up shop after a bad year.

Hedge Fund Compensation:
Never Having to Say You’re Sorry

Investors typically agree to pay hedge fund managers 20 percent of investment gains each year, or what is known as carried interest. (In fin...

Table of contents

• Cover
• Title Page
• Copyright Page
• Dedication
• Contents
• Introduction Ships, Sailors, and Prayers
• Part I
• Part II
• Epilogue
• Acknowledgments
• References
• Notes
• Index
• About the Author