Securities and Exchange Commission
is on the warpath against fraudulent fund ads. In his annual address to the mutual fund industry in May, Paul Roye, director of the SEC's investment management division, warned, "The commission will not tolerate the misuse of performance information to mislead investors." SEC Chairman Arthur Levitt has ordered the commission's examinations staff to conduct a "special review" of fund marketing.
Perhaps the commission should start by looking closer to home. Although one of SEC's biggest beefs with the fund industry has been the presentation of outsize short-term returns in fund ads, SEC rules
fund ads to display this data.
Under SEC rules, if a fund advertises its performance results, it is required to provide one-year returns (in addition to five- and 10-year or since-inception returns). Even if the one-year returns are potentially misleading -- as they often are -- they cannot be omitted.
With a free pass to tout stellar one-year returns, technology fund managers had a field day in the first quarter. Investors poured $30 billion into their funds. Now, many of these new participants in the tech stampede are getting trampled.
Monument Internet, up a sizzling 273% in 1999, has dropped 23% since January.
Amerindo Technology, after a respectable 249% gain in 1999, has given up 30% so far this year. So if you were seduced by these funds' one-year returns and invested in January, you've now lost a big chunk of your investment.
Earlier this year, financial magazines were rife with ads touting triple-digit one-year performances. A quick review of the April and May editions of just three financial magazines yielded ads for a dozen funds that trumpeted triple-digit returns in 1999, yet which were in the red in 2000.
In the May edition of
, for example, the
Internet fund boasted a 216% return in 1999, plus a No. 1 ranking by
and a five-star rating from
. This advertisement would have been of little comfort if you had invested in the beginning of January -- the fund was down 27% in mid-April.
had one word to describe the 100%-plus 1999 performance of its
New Generation and
Small Company Growth funds: "Heavenly." Trouble is, these funds had returned to earth and were down 22%, 19%, 18% and 13%, respectively, two weeks into April.
Nostalgic for '99
Yes, magazine-publishing deadlines may have made it difficult for fund companies to get fresh data into their ads. But judging from some funds' company Web sites, which can easily be updated, they were in no hurry to erase those "heavenly" 1999 returns from investors' minds.
An ad in the May
funds -- two with 100%-plus returns in 1999 -- urged readers to "visit our Web site for more complete information." I did, and it was a little out-of-date. Two weeks into April, the funds' one-year results still were provided only through the end of 1999.
On April 16, the Web page for the
PBHG Technology & Communications fund showed a one-year return of 244% -- for 1999. And its "three-month performance" results covered the last three months of 1999, even after the date was four months into 2000. There was no mention of the fund's 24% decline since January. It appears that these sites were suffering some kind of Y2K glitch.
While funds' nostalgia for 1999 is understandable, the Web sites' omission of first-quarter 2000 data is hard to reconcile with SEC requirements that one-year results be provided as of the end of the most recent quarter.
Nor did the print ads heed guidance issued last month by the
National Association of Securities Dealers
, which is responsible for reviewing fund ads before they are used. The NASD cautioned funds not to "overemphasize recent high-performance figures" and said that funds focusing heavily in technology stocks should state prominently that the advertised performance "probably would not be repeated in the future."
None of the ads I identified noted that a fund's triple-digit returns probably were not sustainable. In the ad that touted the 100%-plus 1999 performance of four Berger funds, each of which was in the red at the time, Berger cautioned in a footnote: "Past performance does not guarantee future results."
Concern About 'Cherry Picking'
Which brings us back to today's million-dollar question: Why does the SEC require these funds to include one-year numbers in their performance ads? The principal reason is "cherry picking," says Susan Nash, an associate director in the SEC's investment management division. The concern is that if one-year results were not required, funds would include one-year results when they were good and omit them when they weren't.
This sounds reasonable in theory, but it doesn't seem to work in practice. Fund families cherry pick by advertising only their outstanding one-year performers. If a family has enough funds, the law of averages says it's bound to have a few stellar performers to feed to the advertising department each month. And if anyone criticizes the funds for using misleading one-year results, they can argue the SEC made them do it.
Nash points out that funds are not protected by the requirement that their ads include one-year performance results. "Funds must still comply, for example, with the rule that performance advertisements can't be materially misleading," she says.
It's not clear, however, why ads that omit any clear indication of their
volatility aren't "materially misleading." For example, an ad for
Federated Asia Pacific Growth showed the fund's one-year 116% return in 1999, but it omitted any mention of its -27% and -7% returns in 1997 and 1998.
The ad hints at the fund's recent travails by mentioning its 10%-since-inception return, but this requires a certain degree of sophistication. For investors who are less statistics-savvy, the since-inception return gives the appearance of stable returns over time. The most effective way to highlight the fund's roller coaster ride would be to require that it line up each calendar year's returns next to each other.
SEC to Provide Guidance
Would the SEC sue a fund company for an ad that boasted a 100%-plus one-year return if it omitted, for example, that its return for the preceding two years was negative? "Arguably, yes," says Douglas Scheidt, an associate director and chief counsel of the SEC Division of Investment Management. "And if additional factors made the omission sufficiently egregious -- such as evidence that a large number of new investors who were attracted to the fund by such ads had lost money after investing in the fund -- those facts might make a strong argument for the Commission to sue the parties involved."
But don't expect the SEC to bring this case anytime soon. Courts are reluctant to side with regulators unless they have provided guidance about what constitutes fraud, and the SEC hasn't done so yet. The SEC staff plans to issue a legal bulletin later this year that will "provide more guidance about when omitting this kind of information may violate the antifraud rules under the federal securities laws," says Scheidt.
This might mean requiring that funds that advertise one-year results show, among other things, one-year results for previous years, as well as worst recent quarterly performances and average performances of other funds in its sector. Funds also might be required to provide information on after-tax returns, expense ratios and concentration in a small number of stocks -- if these factors materially affect the significance of one-year performance results.
And how about abolishing the requirement that funds include one-year results in their ads and instead require, for example, three-year results? According to Nash, this option is not under consideration. So for now, investors will have to figure out what one-year results mean on their own.
Mercer Bullard, formerly an assistant chief counsel at the SEC, is founder and CEO of Fund Democracy, an advocacy group for mutual fund shareholders, in Chevy Chase, Md.