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Avoid being conned by mutual fund advertising

By Daniel Solin

Tuesday - 9/2/2014, 10:45am  ET

Your telephone rings. The call is from an executive recruiter. She has some really good news. You are being offered a position as the fund manager for a large-cap mutual fund. Large-cap stocks are those of companies with a market capitalization value of more than $10 billion. The companies in this group are some of the largest in America and include names such as Microsoft and General Electric.

The benchmark index against which the performance of large-cap fund managers is measured is the Standard & Poor's 500 index. This index includes the stock of 500 leading companies in the U.S.

Unfortunately, there's a catch to this exciting job offer. You will not receive any compensation if your returns do not exceed the returns of the benchmark index. On the flip side, if you beat the index in any calendar year, you will receive minimum compensation of $1 million.

You carefully consider this offer. How difficult could it be to beat the returns of a static index? After all, the fund manager of an S&P 500 index fund is required to track the returns of the index. She cannot move to cash in in anticipation of a market correction or select only those stocks from among the 500 within the index she believes will outperform.

You will not have any of these constraints. You will have extensive analytic resources at your disposal to assist you in determining when to get in and out of the market and to identify which of the stocks comprising the index are likely to outperform.

It seems like a no- brainer. You take the offer.

Then reality sets in.

According to a CNBC article, "8 out of 10 active managers striking out this year," by Jeff Cox, in reference to a report from S&P Capital IQ Fund Research, being the manager of a large-cap mutual fund has been "a rough business." About 80 percent of fund managers have failed to equal or beat the performance of an S&P 500 stock market index fund year-to-date. It looks like you are headed for a year without a paycheck.

Though I feel your pain, I am more concerned about the performance-chasing investors who put money in your fund and in the funds run by your colleagues, who also professed an ability to "beat the market." They lost out on returns that were theirs for the taking and compromised their ability to retire with dignity, if at all.

Although most investors understand the admonition from the Securities and Exchange Commission, that prior returns are not predictive of future returns, many investors are lured by stellar past performance. Mutual fund companies understand that advertising the returns of their best-performing funds will attract assets, which in turn, increases fees.

A 2006 University of California, Berkeley, paper by Sendhil Mullainathan and Andrei Shleifer, "Coarse thinking and persuasion," found that past returns were mentioned, on average, in 62 percent of fund advertisements appearing in "Money Magazine" and in 59 percent of fund advertisements appearing in "Businessweek."

Although SEC rules require a number of disclaimers when advertising a fund's past returns, another study, "Mutual Fund Performance Advertising: Inherently and Materially Misleading?" by Alan R. Palmiter and Ahmed E. Taha, published in 2011, found that these mandated warnings were "completely ineffective."

The authors of this study concluded that the SEC warnings could actually be understood by investors as suggesting the opposite of what they intended: That past returns are a good predictor of future returns. By advertising high past returns, actively managed funds are engaging in a deceptive practice that the study concludes is "inherently and materially misleading."

The solution to this problem is disarmingly simple. All performance-based advertising should be banned. Instead of focusing on factors unrelated to future returns, investors should be encouraged to consider fees, objectives and risk.

Performance chasing is not an abstract problem without practical consequences. In a research note, "Quantifying the impact of chasing fund performance," Vanguard compared the returns of a buy-and- hold strategy to a performance-chasing strategy for the period of 2004 to 2013. It considered the difference in returns across nine fund categories, including large blend, large growth, large value, mid-cap blend, mid-cap growth, mid-cap value, small blend, small growth and small value.

Across the board, the buy-and- hold strategy yielded significantly higher returns. The conclusion of the study was that the top-performing mutual funds, over a 3-year period, demonstrated "weak performance persistence" in subsequent periods. Therefore, investors who relied on prior past performance ended up chasing returns the funds did not repeat.

The takeaway could not be more clear: Ignore mutual fund advertising touting past performance. It really does not predict future performance. It's geared to mislead you and distract you from focusing on the high cost of these funds.

Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth advisor with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is "The Smartest Sales Book You'll Ever Read."

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