Buried deep within the Senate version of the financial reform bill is a provision directing the Comptroller General to "conduct a study on mutual fund advertising," in part to identify "the impact of such advertising on consumers." If the provision makes it into the final bill, and if the Comptroller General does its job, that just might mark the end of funds advertising past performance.
Fund advertising is a big business, with an estimated $6 billion spent annually by fund managers in an effort to attract investor assets. It's nearly impossible to thumb through a major newspaper or financial magazine without coming across an ad for a fund hyping its past performance. (Granted, ads touting stellar performance are less prevalent than they were a few years ago, simply because there's less stellar performance to crow about these days. But rest assured, they'll return as soon as performance does.)
This shouldn't be surprising, of course. There's a great deal of competition for investment dollars, and performance ads are one of the best ways for managers to differentiate themselves from their competitors.
But there is a not-insignificant problem inherent in those ads. Whereas a purchaser of a new Ford car can reasonably expect to enjoy the creature comforts and fuel efficiency they read about in an ad, the experience of a fund investor lured by a performance ad will have nothing to do with the performance they found so compelling. That's because there's very little, if any, persistence in mutual fund performance. Strong returns earned in the past tell you nothing about how that fund will perform going forward, or even if it will be able to outpace the broad market. History has shown that there's a strong reversion to the mean in fund performance -- yesterday's winners become tomorrow's losers.
This reality is why the SEC mandates that all performance ads come with a disclaimer, alerting the reader that "past performance is not a guarantee of future results." But according to a recent study, that disclaimer is ineffective at best, and might even encourage investors to chase performance.
In their study, Professors Alan Palmiter, Molly Mercer, and Ahmed Taha divided a group of would-be investors, and had them view an advertisement touting a fund's past performance. One group's ad was accompanied by the standard SEC disclaimer. Another group viewed the same ad trumpeting the same performance, but accompanied by a much stronger disclaimer, which read:
Do not expect the fund's quoted past performance to continue in the future. Studies show that mutual funds that have outperformed their peers in the past generally do not outperform them in the future. Strong past performance is often a matter of chance.The study found that the group reading the second ad was much less likely to invest in the fund solely on the basis of its advertised performance. But it also found that the SEC's disclaimer slightly increased investors' willingness to invest. The authors speculate that the reason for this lies in the disclaimer's use of the word "guaranteed." For while most investors are painfully aware that there are no guarantees in the capital markets, many hold the mistaken belief that performance persists, and the SEC's disclaimer does nothing to disabuse them of that belief.
Let's hope that, if they are instructed to conduct a study of mutual fund advertising, the people in the Comptroller General's office read this study as they conduct their due diligence. Even better, let's hope that they also familiarize themselves with the overwhelming academic work that illustrates the tenuous link between past and future performance and the tremendous harm that investors do themselves by chasing performance.
If they do, it's hard to believe that they won't reach the only conclusion that a disinterested and logical person could arrive at after conducting such a study, and ban the use of performance figures from all mutual fund ads. Should the industry cry foul and ask how on earth they're expected to differentiate themselves from their competitors, I'd suggest that they consider advertising something that has an explicit link to future performance, like their expenses.