Mutual Fund Performance Ads Inherently and Materially Misleading

Mutual Fund Performance Ads: Inherently and Materially Misleading? Alan Palmiter & Ahmed Taha Penn ILE Conference April 9, 2010

1. Mutual funds 2. Performance ads 3. Materially misleading? 4. SEC warning 5. Regulatory response …

Importance of mutual funds $11 trillion in assets 24% of US public equity 24% of US retirement savings ICI Fact Book (2009)

Who are MF investors? US households w/ MFs = 45% Median HH income = $80, 000 HH income less than $100, 000 = 63% Median HH financial assets = $200, 000 Median HH investment in MFs = $100, 000

MF investors chase past returns • Studies – Capon et al. 1996 – Wilcox 2003 – ICI 2006 • Heuristics – Representativeness (% skill) – Anchoring (% expect) – “Past is prologue”

en tm to bj to if es tiv ec s ce y ex ld an in d he re ks ha ris en qu ge , se on ar ch xc Ta le s Sa d re iti es rs pe ur ec pa m co ve s In ce an rm fo Pe r fs ice nd ce es ns an rm fo pe ex Fu er lp d an Pr ica so Ty pe Hi st or es Fe Understanding Investors Preferences for Mutual Fund Information ICI (2006) 80% 60% 40% 20% 0%

Active MF performance not persistent • Studies on (growing) lack of MF persistence – Cuthbertson et al. 2006 – Barras et al. 2008 – Fama & French 2009 • Explanations – High costs (fund size) – Market efficiency – Hedge funds (trading strategies)

Performance persistence Do actively-managed equity MFs outperform market/benchmarks? Barras et al. (2008) • 2, 076 domestic equity MFs • Period 1976 -2006 • Test for abnormal net positive returns 2. 20% 0. 60% Sub-normal Abnormal (skill) 97. 80%

Performance persistence Do actively-managed equity MFs outperform market/benchmarks? Fama & French (2009) • 3, 156 domestic equity MFs • Periods 1974 -2002, 1984 -2006 • Test for abnormal net positive returns 3. 0% Not cover costs Cover costs (skill) 97. 0%

1. Mutual funds 2. Performance ads 3. Materially misleading? 4. SEC warning 5. Regulatory response …

Proportion of total MF ads = 50% Average advertised performance = + 6. 0% Performance ads increase fund flow Advertised funds don’t continue to outperform* * often underperform

SEC Rule 482 specifies what periods for past returns specifies how past returns are calculated requires disclaimer on performance persistence

1. Mutual funds 2. Performance ads 3. Materially misleading? 4. SEC warning 5. Regulatory response …

Securities Act of 1933 Section 17(a) It shall be unlawful for any person in the offer or sale of any securities … to obtain money … by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading … … ads say/imply performance matters … … investors consider performance to be important … … performance rarely (if ever) matters …

1. Mutual funds 2. Performance ads 3. Materially misleading? 4. SEC warning 5. Regulatory response …

SEC warning “Past performance does not guarantee future results; 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 current performance may be lower or higher than the performance data quoted. ”

No caution [Nothing]

Bespeaks caution (more accurate) “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. ”

Experiment • Participants (535 law/business students) – 47% with MF investing experience – 94% intending to invest in MF in future • Control conditions – No Disclaimer – No Data and No Disclaimer • Disclaimer Strength Manipulation – Standard – “… past performance cannot guarantee future results…” – Strong – “Do not expect the fund’s quoted past performance to continue in the future…” • Disclaimer Prominence Manipulation – Standard – 11 -point non-bold font – High – 12 -point bold font

Dependent Variables • Expectations regarding fund’s performance – Agree with statement: “The fund will outperform other funds in the future. ” – “What do you expect the fund’s total return to be in the 12 -month period following the advertisement? ” • Willingness to invest – “Would you allocate a portion of your retirement money to this fund? ” – “What percentage of your retirement money would you be willing to allocate to the fund? ” • Belief about performance persistence – Agree with statement: “The fund’s past performance is a good predictor of its future performance. ”

Expect advertised fund to outperform? [Scale 1 -7] • Standard Disclaimer vs. No Disclaimer (p = 0. 82) • Strong Disclaimer vs. No Disclaimer (down 15. 9% /p < 0. 01) • Strong Disclaimer vs. No Performance Data (p = 0. 62)

How willing to invest in advertised fund? [Scale 1 -7] • Standard Disclaimer vs. No Disclaimer (p = 0. 93) • Strong Disclaimer vs. No Disclaimer (down 12% /p < 0. 01) • Strong Disclaimer vs. No Performance Data (p = 0. 12)

How much invest in advertised fund? [percentage of portfolio] • Standard Disclaimer vs. No Disclaimer (p = 0. 90) • Strong Disclaimer vs. No Disclaimer (p = 0. 05) • Strong Disclaimer vs. No Performance Data (p = 0. 25)

1. Mutual funds 2. Performance ads 3. Materially misleading? 4. SEC warning 5. Regulatory response …

Testimonials (weight-loss programs, work-at-home opps) FTC approach • Disclaimer: “results are not typical” • Guide (2009): must “disclose generally expected performance” • Based on empirical studies that consumers assume typicality and prior disclaimer ineffective

Reforms … • SEC – Study investor beliefs, performance persistence – Require stronger disclaimer / inform investors – Prohibit performance ads (performance info? ) • Courts – Case-by-case approach – Put mutual funds to proof • Congress – Hearings on investors, fund performance – Adopt legislative standard?

SEC website “Past performance is not a reliable indicator of future performance. So don’t be dazzled by last year’s high returns. . A fund’s past performance is not as important as you think. Advertisements, rankings, and ratings often emphasize how well a fund has performed in the past. But studies show that the future is often different. This year’s “number one” fund can easily become next year’s below average fund. ” SEC Website - Invest Wisely: An Introduction to Mutual Funds

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