Investing in mutual funds reminds me of a common street hustle. While your attention is focused on shuffling the shells, you lose track of the pea. It’s an effective hustle. The mutual fund industry has refined it into an immensely profitable one.
Mutual funds are big business. According to the 2013 Investment Company Fact Book published by the Investment Company Institute, $14.7 trillion is invested in U.S. mutual funds. Approximately 45 percent of U.S. households own them. The median amount invested in 2012 was $100,000. The median household income of these mutual fund investors was only $80,000. Clearly, mutual funds are an important part of a retail investor’s retirement planning. Yet many of these hardworking Americans take their eye off the ball when making decisions about mutual funds. They are swayed by past performance and ignore fees and risk. The mutual fund industry couldn’t be happier with this sad state of investor ignorance.
Almost all investors are familiar with the disclaimer required to be inserted in the prospectus of publicly traded mutual funds: “Past performance does not guarantee future returns.” Yet mutual fund advertising is often about the stellar past returns of its best-performing funds. Mutual fund companies tout past performance for one reason: It works, even though the relationship between past and future returns is highly problematic. One 2002 National Bureau of Economic Reserach study, “Mutual fund flows and Performance in Irrational Markets,” found that the “relative performance of mutual fund managers appears to be largely unpredictable using past relative performance.” If future performance is largely unrelated to past performance, it is vexing that so many investors ignore or remain unaware of this data.
A study published in September 2010 in the Journal of Empirical Legal Studies by Molly Mercer, Alan Palmiter and Ahmed Taha examined how effective the standard disclaimer required by the Securities and Exchange Commission was in dissuading reliance on past performance. The study engaged in a series of controlled experiments using MBA students, law students and undergraduate business students.
The study found that the standard disclaimer about past performance is ineffective in dissuading reliance on advertised past returns. It didn’t reduce participants’ expectations about future returns or change their willingness to invest in funds with stellar past returns.
Making the disclaimer more prominent had little or no effect on the participants. However, when a much more strongly worded disclaimer was substituted for the standard one, there was a significant impact on the participant’s willingness to invest in the fund. The new disclaimer stated:
“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.”
It would be relatively easy for the SEC to mandate a stronger disclaimer by mutual fund companies. I suspect the mutual fund industry would mount a massive lobbying campaign against this change.
Don’t wait for the government to protect you from a disclaimer that fails to provide the information you need to make an informed decision. Past performance really is irrelevant. Concentrate on things you can control, like the expenses the fund charges (called the “expense ratio”). You will find the lowest expense ratios in exchange-traded funds and index funds from major fund families such as Vanguard.
Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth advisor with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His next book, “The Smartest Sales Book You’ll Ever Read,” will be published March 3, 2014.