In the wake of the trillions of dollars lost in the recent bust, it’s clear that many people made foolish investment decisions in recent years. It is popular to blame the people who market the various assets that went bust: fund managers, stock brokers, and real estate agents. I think much of the blame is well placed. Often members of these groups present a misleading picture of future prospects to investors; often the investors are lead astray. There is a need for a combination of stricter regulation and improved investor education. In this column we will focus specifically on advertisements of mutual funds.
The securities laws, like other consumer protection laws, forbid advertising which is “false or misleading”. But both of these terms must be interpreted in the context of the sophistication of the consumer. A statement may be totally false and yet be permitted, if it is concluded that any reasonable consumer will understand that it is merely an exaggeration for image purposes. This is known as “puffery”. Conversely, a statement can be totally accurate and yet be misleading if the consumer does not know how to interpret it. This is the case with virtually all fund advertising which tries to attract consumers based on past results.
The most blatant kind of misleading statement is when the ad presents a misleading picture of past returns in and of themselves. At the risk of providing a school for scandal, I will mention a few:
* Omitting fees: Giving the total return on the investments, omitting the fees and other charges that leave the investor with far less.
* Selectivity in funds: If you have twenty funds, then by dumb luck about ten will beat the market in any given year and a couple will probably beat the market a few years in a row. Advertise the ones that were lucky.
* Selectivity in duration: If you want to push only a single fund you can game the time horizon. Just by chance, a large majority of funds will show “above-average” returns for some number of years in the past decade. If you did badly last year, maybe you did well two years ago and the two-year average is above average, etc.
All of these practices are illegal according to securities laws, though in my opinion many ads push the limits of the permissible.
The second kind of misleading statement is when the numbers are true but the consumer is misled into an unwarranted consequence. For instance, if I write, truthfully, that investors in my fund beat the market each of the last five years, then the reader may infer that I will also beat the market in coming years. Research shows that investors do in fact pour money into investments that have one or two good years.
For this reason, the better ads state clearly, “Past performance is no guarantee of future results.” But there are two problems with this disclaimer. The first is that it is often missing, particularly in Israel. This exact phrase is not required by law; rather, it is one way of fulfilling the legal mandate of informing the investor that all funds have a risk of loss. The investor gets the impression that good past performance indeed guarantees good future results.
An even worse problem is that this disclaimer, meant to forestall misleading conclusions from performance results, is itself quite misleading. It implies that past performance is a good predictor of future results, merely not a guarantee. In fact, mountains of research over many decades has failed to produce convincing evidence that past performance of mutual funds tells us anything about future performance. The most that can be said is that a few intrepid researchers have done sophisticated statistical tests on very large quantities of data and have found evidence that a small number of good performers are in fact skillful at picking good stocks, and a small number of bad performers are skillful at picking bad ones (just as difficult). Even according to this study, the overwhelming majority are just lucky or unlucky. Most studies are not able to discern any meaningful relationship at all.
So having an investment fund trumpet its returns and then print a small disclaimer “Past performance is no guarantee of future results” is something like having a nutritional supplement trumpet “Cancer preventative” and then have a small disclaimer stating, “Using this preparation does not guarantee that you will not get cancer.” This seeming “disclaimer” actually shows confidence in the power of the supplement; it seems to place it on the level of the most effective and tested medical procedures, which after all can also not guarantee results.
The situation in Israel is particularly dismaying. A number of leading mutual fund companies state explicitly on their web sites that the most important thing to examine in choosing a mutual fund is past performance. It is clear that better regulation of these representations is needed.
The results of this sad situation are that investors are misled, and that fund managers take on excessive risk in the hopes of lucking in to an unusually good year that will attract new money.
Existing securities laws encourage the unfounded impression that good past results predict good future results. The situation in Israel is particularly grave. Advertising laws and practices should be altered to give investors a much better idea of the benefits and risks of competing funds.