A Faculty Essay by Professor Ahmed Taha
Mutual funds are a cornerstone of our national savings and retirement systems. There are over 8,000 mutual funds in the United States, holding a total of more than $13 trillion in assets. Mutual fund ownership is widespread, with 44 percent of U.S. households owning mutual funds, because mutual funds are a primary way that Americans save for retirement. Fifty-one percent of individual retirement account (IRA) and defined-contribution retirement plan assets (such as 401(k) plans) are invested in mutual funds.
Consistent with the long-term investment horizon of many fund investors, almost half of investors’ mutual fund holdings are in equity funds, i.e, funds that invest in stocks. The portfolios of equity funds are either passively or actively managed. Passively managed funds typically are index funds, managed to track the returns of a specified market index, such as the S&P 500 Index. Most equity funds, however, are actively managed in an attempt to beat the market (or a specified benchmark) by superior stock picking, market timing, or both. Actively managed funds typically engage in more research and trading activities than do index funds, and thus generally have higher costs.
With the job of deciding how to allocate money among different mutual funds falling mostly on individual investors, our nation’s financial well-being depends upon investors making wise fund choices. An extensive body of research has examined how investors choose among the vast number of funds available to them. Unfortunately, these studies paint a disturbing portrait of the typical mutual fund investor. In general, the studies have found that most fund investors are uninformed and financially unsophisticated—unaware of the investment objectives, composition, risks, and fees and expenses of their funds. Investors, however, pay great attention to funds’ historical returns. Indeed, studies have found that this might be the most important factor to the typical investor choosing among funds.
Unfortunately, studies of actively managed equity funds have also found little evidence that strong past returns predict strong future returns. Chasing performance is a fool’s game. Why do high past returns generally fail to predict high future returns? A primary reason is that luck is a major factor in a fund’s returns. A fund that markedly outperforms its peers during a particular time period generally does so because of luck, not because of its manager’s stock-picking skill. This luck, however, usually does not persist.
Nonetheless, mutual fund companies routinely advertise the returns of only their high-performing equity funds. This selective advertising misleads investors by obscuring the role of luck in past returns. A company operating many funds will generally have some funds perform well simply because of luck. However, because investors only see advertising of the returns of the company’s high-performing funds, they are more likely to attribute the high returns to the fund managers’ skill rather than luck and thus mistakenly believe that the returns are likely to continue.
Fund companies advertise their high-performing funds because these ads exploit and encourage investors’ tendency to chase funds with high past returns. Performance ads attract returns-chasing investors and thus increase the asset-based fund management fees that the fund companies earn. Performance ads, however, do not benefit investors; advertised high-performing funds generally do not continue to outperform other funds.
The timing of performance advertisements also harms investors. Fund companies use performance advertisements much more often during stock market upswings than downswings, because they have higher returns to advertise when the stock market has been performing well. This phenomenon is very important. It means that the timing of performance ads encourages investors to make a major investing mistake: poor asset allocation. Performance ads prompt investors to buy equity funds primarily when recent stock returns have been high. This is the opposite of what investors should do.
The Securities and Exchange Commission (SEC) has recognized the troubling tendency of fund investors to chase past returns. SEC rules specify how funds may calculate and present past performance in their ads. The rules also require that performance ads include a warning disclosing:
“that past performance does not guarantee future results; that the investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost; and that current performance may be lower or higher than the performance data quoted.”
At first glance, one might expect this SEC-mandated warning to temper investors’ focus on past performance. The effectiveness of performance ads in attracting investors’ money, however, suggests otherwise. Other evidence also indicates that the SEC’s warning falls on deaf ears. A recent study that I conducted with two colleagues found that investors who receive the SEC’s warning are as likely to invest in a fund advertising high past returns—and have the same expectations regarding the fund’s future returns—as are investors who receive no warning at all.
The SEC-mandated warning likely fails, at least in part, because it is so weak. In our study, we found that participants who were less likely to believe that the advertised fund’s past performance was a good predictor of its future performance were also less willing to invest in the advertised fund. The SEC-mandated warning, however, fails to convey that strong past performance is a not a good predictor of strong future performance. Instead, it merely informs investors that past performance does not “guarantee” future results, that returns vary, and that investors in the fund might actually lose money. It is unlikely that many investors do not know that an equity fund’s returns are not guaranteed, can vary over time, and may be negative. The fall in stock prices after the dot-com bubble burst and during the recent financial crisis have made clear to investors that the stock market is volatile and subject to dramatic declines. In fact, the SEC’s warning that past performance does not “guarantee” future results can even be read as implying that high past returns are a good predictor of high future returns, just not a guarantee of them.
The current regulation of mutual fund performance ads is inadequate. Performance ads, as currently regulated, are inherently and materially misleading. Past returns in performance ads, although factually accurate, mislead investors because they falsely imply that these high past returns are good predictors of high future returns. In many performance ads, this implication is not subtle. For example, performance ads with headlines touting the advertised fund’s “proven” performance can only be understood as saying that such past performance predicts likely future performance.
However, even performance ads that lack such text are misleading. By their very nature, performance ads inherently imply that high returns will likely persist. The only conceivable purpose of performance ads is to convince investors that a particular fund that has performed well in the past is likely to continue to do so in the future. Indeed, an ad that touts a fund’s low past returns seems unimaginable. By implying that strong past performance is likely to continue—the clear inference of reasonable investors—mutual fund companies use performance ads to engage in what can be described only as a form of securities deception.
What can be done about performance ads? The SEC should at least strengthen its required warning. The current warning does not adequately convey that high past returns poorly predict high future returns. In contrast, our study found evidence that investors might significantly temper their performance expectations if performance ads contained a warning that strong past performance generally results from luck and thus should not be expected to continue in the future.
However, given the inherently misleading nature of fund performance ads—and the difficulty of getting investors to actually read a warning in an advertisement—stronger action might be necessary. In particular, the SEC should seriously consider prohibiting equity fund performance advertising altogether. This prohibition would encourage investors to instead focus on more important fund characteristics such as the fund’s costs, the asset classes in which the fund invests, and the extent to which the fund’s investment objective and risk matches the investment objective and risk tolerance of the investor.
This article is adapted from Professor Taha and Professor Alan Palmiter’s article, “Mutual Fund Performance Advertising: Inherently and Materially Misleading,” Georgia Law Review (2012). That article has been selected to be reprinted in the 2013 edition of the Securities Law Review.