Most of us have things in our past we would like to forget.

Personally, I'm not proud of breaking a classmate's collarbone in fourth grade. In my defense, I was reining King of the Hill and I thought I was under siege. (Turns out she was just trying to cross to another part of the playground - a judgment error in the heat of battle.)

Mutual fund companies also have past embarrassments they would like to hide - funds with really poor returns. Unlike the rest of us, fund companies have an easy way to deal with their unpleasant history. They can make it disappear.

A Wall Street Journal article recently publicized this little trick*. Poor performing mutual funds are often merged into other funds, or they may be liquidated altogether. Either way, the bad grades are completely wiped off the report card.

In academic circles, erasing bad performance is known as "survivorship bias." The winners continue to keep score (because it looks good), and the losers fade away. It sure makes the past look a lot rosier. It's like claiming par on a golf hole after taking three mulligans.

The Journal article highlighted the "market-neutral" fund category, a relatively new creation that began gaining popularity around 1997. These funds buy some stocks and sell others "short" (i.e. betting they will fall in price). The pitch was that a "skilled" manager should be able to enhance returns by profiting from both rising and falling stocks.

Morningstar, which tracks fund performance, reports an average return of 5.36% annually over the past 15 years for the market-neutral category (July 31, 2012). But that only reflects the survivors. Adjusting for all of the losing funds that were swept under the rug, the average return was just 1.68%. In other words, a lot of dreadful funds were wiped off the books. In fact, the article found that only 32 of the 62 market-neutral funds introduced between 1997 and 2007 are still in existence.

Even worse, the trendy "market-neutral" strategy designed to profit from market volatility didn't come close to living up to its billing. A simple S&P 500 index fund would have substantially outperformed the average market-neutral fund - to the tune of more than 2.5% per year.     

The moral? Beware of financial innovation - and the revisionist history used to promote it.