Beware of performance ads, says fund analyst

(February 16, 2004) The mutual fund advertising landscape has changed dramatically this RRSP season. After several years promoting the benefits of long-term investing and financial planning, the fund industry has returned to performance-based advertising. That’s a dangerous game, says analyst Dan Hallett.

Historical data on fund flows reveals a strong tendency for investors to chase recent past performance, Hallett wrote recently in his weekly online column.

In 1993, Hallett says, many funds delivered triple-digit returns, paced by aggressive resource-based and emerging market products. “Guess where investors’ attention shifted to in 1994?” he notes: “You guessed it: aggressive resource, metals, Asian and emerging markets funds.”

A similar pattern emerged in 1994 when interest rates rose sharply and investors bailed out of the bond market to the tune of $6.5 billion.

“The point is that prices of financial assets tend to be cyclical,” Hallett says. “Panicking at what seems like an awful time to invest and piling on when certain segments appear to be ‘sure things’ inevitably leads to poor performance and disappointment.”

Hallett points to a study of more than 400 mutual fund ads conducted by FundMonitor.com in 1998. “The funds featured in nearly half of these ads saw subsequent one-year performance drop by more than 10 percentage points. In one-quarter of the ads, performance dropped by more than 25 percentage points. In short, the ads lured investors after they’d posted strong returns, and subsequently failed to live up to the advertised figures. “

To avoid repeating past mistakes, Hallett says investors and advisors should study mutual funds ads carefully and set realistic expectations.

“Ads boasting of extraordinarily high returns, like 50% and above, were likely achieved either in a risky asset class or with an aggressive management style,” he says. “These funds and firms have the greatest potential to disappoint.”

While performance is important, investment decisions should never be based on that factor alone. Hallett advises, “I know both investors and advisors know this well, but the continuing trend of ‘investor misbehaviour’ suggests a reminder won’t hurt.”

Filed by Doug Watt, Advisor.ca, doug.watt@advisor.rogers.com