In 1979 the
Securities and Exchange Commission
opened a Pandora'sbox: It allowed funds to advertise past performance. The SEC has spent thelast 24 years trying to repair the damage.
Last week the SEC took a new step to protect mankind from potentiallymisleading performance figures: It unveiled rule amendments that will require funds to modify the way they advertise past performance. In a nutshell, fundswill have to warn of risks and include a phone number or Web site addressin their ads, so investors can get up-to-date performance information.
When the SEC first proposed this change last year, it said: "
Theseproposed amendments are part of our continuing efforts to raise the bar forfund-performance advertising so that investors are informed, and notmisled, by that advertising."
Fat chance. It would be easier to stop moths from flocking toa flame than for the SEC to stop investors from making a beeline tofunds 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
by almost 8%.
Thanks in part to ads, these funds attracted the most inflows frominvestors 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.
The freedom to show performance started the great paper chase byinvestors to hop into the fund with the best track record, which seems aslogical as betting that Tiger Woods will perform above average in futuregolf tournaments. But things didn't always work out so well for theseinvestors.
Almost immediately after allowing funds to advertise performance, theSEC realized the error of its ways and started adding amendments andregulations.
The latest rule amendment targeting ads will require funds to:
Make accessible through a phone call or Web site more currentperformance figures than the quarter-end figures in current advertisements,plus be clearer about the performance dates shown.
Remind investors that, "No foolin', people, past performancereally, really, does not guarantee future returns," and also add thatcurrent performance may be lower or higher than the performance quoted.
Give some heightened exposure to the fund's expenses,objectives and risks to counter the warm glow emanating from theperformance figures.
These rules, of course, will do nothing to prevent investors fromhopping into yesterday's best funds. Even baring fund advertisementscompletely wouldn't help. Unlike the situation in 1979, there are now numerous places to go fora ratings "fix" on all the funds with the hottest recent track records. Andunlike fund ads, newspapers and Web sites don't have to follow anydisclosure rules when they highlight all the hot funds.
Are there any regulatory solutions? Not likely. We need a shift in howpeople invest in funds. This includes how the media and researchers coverfunds -- they are just as guilty as fund companies of promoting and toutingfunds that are on a soon-to-end hot streak. We're all quick to blame funds foradvertising their best selling points, when far more money gets invested inno-load funds based on favorable ratings, reports, reviews, rankings andarticles.
What's an investor to do? Avoid funds in performance-featuredadvertisements. Steer clear of services that rate "hot" funds. In general,beware of categories of funds that, because of past performance, are mostmarketable.
Here are some things funds could do with their advertisements if regulators really want to give investors a true picture of a fund's past performance:
If a manager departs, all references to the fund's trackrecord should highlight this fact prominently.
Show a fund's worst peak-to-trough performance next to otherperformance data.
Compare a fund's expense ratio and risk level with those of other funds.
Show how typical investors have done in the fund bycalculating their collective returns based on when they bought and sold.This cash-flow-based figure can be calculated by fund companies, as theyare privy to investor inflows and outflows.
Or better yet, maybe the next step is to run public-serviceannouncements akin to the ubiquitous antidrug ads: "This is your portfolio.This is your portfolio after buying funds with hot track records. Anyquestions?"