Is it misleading to imply that looking in the rearview mirror will help work out what will happen in the future? Photo / Thinkstock
It seems like just about every second iteration of this column is critical of the fund management industry which is a bit negative but hey, let's be honest, there is a lot of great material out there!
Whilst it is often easier to buy into the spin and just report good news it is the responsibility of the media to provide a balance to the optimistic scenarios frequently promulgated by the "investment industry", and it's good fun as well. Fortunately a good number of journalists share this sceptical view of the investment world.
One of my favourite reads is the Buttonwood column in the Economist Magazine. Buttonwood writes anonymously on the finance sector covering topics ranging from Polish pensions to the Fed Model. The author is Mr Philip Coggan. Philip wrote the Longview section in the London Financial Times for about a decade and he has generously helped me out with ideas and comments over the last fifteen years.
One of his latest stories referred to a recent study by two US law professors on fund management performance advertising. Not many things are certain in the investment world but you can be reasonably confident that when law professors investigate the investment scene their conclusions are rarely favourable. We saw that in "To Educate Or Legislate" back in May and today's story continues that critical theme.
Below we review the findings of the study. It is entitled "Mutual fund performance advertising: inherently and materially misleading?" It's good stuff so let's get started. The authors are Professors of Law from Wake Forest University in North Carolina. They make a number of points but the main ones are that:
* Fund management companies advertise strong past performance.
* High past returns are poor predictors of future returns.
* Investors chase high past returns.
* An often overlooked impact of performance advertising is that it deflects investors' attention away from the important determinants of performance and thus hampers discerning the relative attractiveness of managed funds ... which of course involves looking at annual fees.
But let's start at the beginning.
The authors make the point that mutual fund companies, known as managed funds in NZ, regularly promote their funds on the basis of their past performance with the implication being that the advertised high historic returns are likely to continue. This happens in NZ all the time and there have been some egregious examples whereby fund managers have data-mined and highlighted returns for periods as short as 18 months.
The professors conduct an extensive review of the literature on past performance and they conclude that "past performance is perhaps the most important factor investors use to choose equity mutual funds" but "strong performing funds generally do not continue to outperform other funds". The main reason high past returns don't predict future returns is that "luck is a major factor in a fund's returns" and as we know your luck can change. Many readers will disagree with this so before you spit the dummy read the document, "Mutual fund performance advertising: inherently and materially misleading", pages 7 to 12.
The professors reckon that the regulatory authorities in the US (the SEC) should be more aggressive in preventing misleading advertising and they go as far as to suggest that performance advertisements should be prohibited completely.
They argue that a ban on performance advertising would assist retail investors to focus on more important fund characteristics such as the fund's annual running costs, its risks and the extent to which it's investment objectives match that of the individual.
The paper reviews the current laws which regulate fund performance advertising in the USA and it is interesting to compare the rules which prevail there with those in NZ. In the US performance advertisements are able to highlight periods where performance has been extraordinary (data-mine) but they must also report total returns for the last 1, 5 and 10 years.
The SEC has chosen these time periods because they give investors information regarding "the actual investment experience of a short, medium term and long term investor". Performance must be after annual fees (not the case in NZ) and if there is a one off entry fee they must incorporate it into the returns or it must be noted that "the performance data does not reflect the deduction of the initial fee and, if reflected the performance quoted would be reduced".
Relative to the US law NZ legislation looks deficient, to put things mildly. We have the standard "past performance is not a guarantee of fund returns" but according to the FMA "there are no specific laws applicable to the advertising of managed funds". Instead the Securities Act 1978 says that no advertising is permitted that will deceive, mislead or confuse and the Fair Trading Act 1986 says the same thing.
But the key is, of course, how you define "misleading" and it seems that the law professors in North Carolina would view advertising in NZ as being "misleading" despite it being lawful in this country. The Financial Markets Conduct Act is on the horizon and it comes into force in 2014 but after wading through its 463 pages it doesn't appear to offer any additional protection for retail investors in this area.
The advantages of the US system in terms of applying information to help retail investors make the right decision is further improved upon by the content of the prospectus as it relates to displaying performance.
In the US the SEC requires that fund managers plot a graph of performance against a relevant benchmark. In NZ the inclusion of the graph is voluntary and the choice of benchmark is up to the fund manager. As we know performance is relative and the best way of looking tall is to stand beside a short person. For this reason the benchmarks used in NZ aren't always relevant.
The logic for banning performance advertising is based on the fact that although the SEC compels fund managers to include a warning that historic returns are not indicative of future returns, anecdotal evidence suggests that this warning does not do much good. In an experimental study the authors conducted investors who received the SEC's warning were as likely to chase funds with high past returns as investors who did not receive any warning at all.
The authors are of the view that the current regulation of managed funds performance advertisements in the US is "grossly inadequate by implying that strong past performance will continue - the clear inference of reasonable investors - performance advertisements are used by fund managers to engage in what can be described only as a form of securities deception".
This last point is important. As mentioned the professors conducted an experiment which showed that many investors completely ignored the SEC warning that past performance is not a good way of differentiating between funds. If investors ignore this warning we should ask ourselves in NZ how effective the current local regime of compelling fund managers and advisers to disclose conflicts of interest will be?
Even ignoring the fact that most people don't read the disclosure documents one would have to conclude that disclosing conflicts of interest (COI) isn't likely to materially inform investors. Far better perhaps to adopt the Australian/UK model and remove the COI. The bottom line is that everyone berates mum and dad for doing dumb things in matters financial but lobbying from the people that benefit from these mistakes appears to stop any meaningful laws to improve their decision making.
Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request.
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