Fact check: Is this mutual fund ad misleading?

(MoneyWatch) Commentary Last month, I read an advertisement in Investment News, a weekly publication for financial advisors. The advertisement for Prudential mutual funds announced, in big bold capital letters, "HIGHLY RATED BY MORNINGSTAR. POWERED BY PRUDENTIAL INVESTMENTS." It went on to boast that "over 60% of our Morningstar-rated funds have earned 4 or 5 stars,*" the top two ratings of the five star historic performance rating system.

The ad was similar to this more updated Prudential brochure, which can be found on the company's web site. You can read the smaller print from this brochure, but I'll get back to that in a bit.

The claim that 60 percent of Prudential funds received the top two Morningstar ratings appears to be conclusive evidence that Prudential funds are indeed highly rated by Morningstar. That's because Morningstar only gives 10 percent of each category of funds a five star rating and 22.5 percent of the funds a four star rating. The big bold print appears to imply that 60 percent of Prudential mutual funds are in the top 32.5 percent of performers.

Fact Check

Now before handing your money over to Prudential Investments, you may want the following facts on how Morningstar actually ranked Prudential funds in each of four fund categories. Here are the average rankings:

Domestic stock: 3.1 stars
International stock: 2.5 stars
Municipal bonds: 3.0 stars
Taxable bonds: 3.2 stars

A three star ranking translates to average mutual fund performance, and, thanks to expenses, a mutual fund that turns in average performance typically underperforms the index it is trying to beat. The big bold print on the brochure claims that the funds are highly rated, but my interpretation is that Morningstar considers Prudential mutual funds merely average.

Prudential responds

I spoke to Scott Benjamin, Executive Vice President of Marketing for Prudential Investments, who defended the advertisement's accuracy. While he wasn't aware of the overall average Morningstar ratings I noted above, he pointed out that the advertisement clearly said "for class Z shares." It stated this in smaller print in the upper half of the Investment News advertisement and on page two of the brochure.

Prudential Brochure (Click to read)

Class Z shares are a lower cost version of a mutual fund that cannot be purchased directly by the investor and can only be purchased through an advisor or a company's retirement plan. For example, the brochure lists the Prudential Government Income Fund (PGVZX) as a four star rated fund with a 0.68% expense ratio. If you bought the B share class of the same Prudential Government Income Fund (PBGPX), you'd own a two star rated fund with a 1.68% expense ratio. That's an above average fee level and below average performance, according to Morningstar. Typically, the advisor charges the client an additional fee in the Z shares, while the B shares have fees built in, and Prudential pays a "distribution" fee. The overall ratings of the funds are based on a weighted average of all share classes. Morningstar notes Prudential Investments have an overall average expense ratio so it's not surprising to see average performance.

Benjamin insisted the advertisement was accurate and strongly disagreed with my assertion that it was misleading, noting that it was in compliance with FINRA regulations. He also stressed that the company's funds are sold largely through financial advisors, and because more and more sales are coming through broker/dealer platforms that feature Z shares, Prudential now sells more in this share class than any other. Benjamin further pointed out that the advertisement in Investment News was directed to financial advisors, who understand share class pricing.

Still, I asked him why not be more clear and have the advertisement state something like "60 percent of our lower cost share class funds are highly rated by Morningstar"? Benjamin responded by saying that's what the advertisement does state.

My take

This Prudential advertisement is just an example of how the financial services industry selectively includes certain facts. Nowhere in the advertisement was there a disclosure that Morningstar considers the overall average of all of Prudential's mutual funds to have ratings between 2.5 and 3.2 stars. And you have to read on to see that the claim of being highly rated by Morningstar only applies to certain share classes. I'm saddened to say that I'm sure Prudential is right in stating it complies with FINRA regulations.

Prudential and I are just going to have to agree to disagree on whether the advertisement and brochure could be more straight forward. Still, my advice is to read any advertisement with the following in mind:

Spend even more time reading the small print than the large. Ask yourself what's not in the advertisement.


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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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