New Fund Rules Won't Solve an Old Problem

In 1979 the Securities and Exchange Commission opened a Pandora's box: It allowed funds to advertise past performance. The SEC has spent the last 24 years trying to repair the damage.

Last week the SEC took a new step to protect mankind from potentially misleading performance figures: It unveiled rule amendments that will require funds to modify the way they advertise past performance. In a nutshell, funds will have to warn of risks and include a phone number or Web site address in their ads, so investors can get up-to-date performance information.

When the SEC first proposed this change last year, it said: "[These] proposed amendments are part of our continuing efforts to raise the bar for fund-performance advertising so that investors are informed, and not misled, by that advertising."

Fat chance. It would be easier to stop moths from flocking to a flame than for the SEC to stop investors from making a beeline to funds with bright, marketable track records.

What is so dangerous about advertising how a fund has performed? Basically, a fund's past success isn't very indicative of future success. Worse yet, it can lead to underperformance.

A study called "Truth in Mutual Fund Advertising -- Evidence on Future Performance and Fund Flows" backs up this point. The study followed the returns of hundreds of funds that appeared in ads touting past performance in the mid-1990s. The post-advertisement performance was abysmal -- over the next year after the ads ran, the funds trailed the S&P 500 by almost 8%.

Thanks in part to ads, these funds attracted the most inflows from investors shortly before the underperformance. The study appeared in the Journal of Finance, an academic journal published since 1946 by the American Finance Association, back in April 2000 -- right before a market crash that likely led to even worse returns for recently advertised funds. Leaf through a financial magazine from March 2000 and you'll see ads for dozens of funds about to tank. This is a problem that's getting worse, not better.