Tuesday, October 10, 2017

Mutual Fund Performance Ads- Better not read

Mutual funds are a cornerstone of our Canadian savings and retirement systems. There are thousands of mutual funds in Canada, holding a total of more than $1.4 trillion in assets. Mutual fund ownership is widespread. As of 2015, 33% (4.9 million) of Canadian households held mutual funds. Mutual funds account for 31% of Canadians’ financial wealth.

Consistent with the long-term investment horizon of many fund investors, more than half of investors’ mutual fund holdings are in equity funds, i.e., funds that invest in stocks. The portfolios of equity funds are either passively or actively managed. Passively managed funds typically are index funds, managed to track the returns of a specified market index, such as the S&P/TSX. Most equity funds, however, are actively-managed in an attempt to beat the market (or a specified benchmark) by superior stock picking, market timing, or both. Actively- managed funds typically engage in more research and trading activities than do Index funds, and thus generally have much higher costs to manage (or what's known as "MER's") 

Uninformed investors bear the burden of fund selection

With the job of deciding how to allocate money among different mutual funds increasingly falling on individual investors, our nation’s retirement income security depends to a growing extent upon investors making wise fund choices. An extensive body of research has examined how investors choose among the vast number of funds available to them. In general, the studies have found that most fund investors are uninformed and financially unsophisticated—unaware of the investment objectives, composition, risks, fees and long-term impact of expenses on their funds. Investors, however, do pay great attention to funds’ historical returns. Indeed, studies have found that this might be the most important factor to the typical retail investor choosing among funds.

Past performance not a good indicator of future results

Studies of actively-managed equity funds have found little evidence that strong past returns predict strong future returns after fees. This is a very important fact.  Chasing performance is therefore a fool’s game and not a good reason to select a fund. Fund companies advertise their high-performing funds because they have proven effective at exploiting and encouraging investors’ tendency to chase funds with high past returns.  Simply put, investors tend to put their money with fund managers who have succeeded in the PAST, despite the fact that this will not mean that the fund manager will succeed in the future.

Mutual Fund Ads: inherently problematic

Investors receive these performance ads via email, newspapers, TV/BNN, social media, so-called “free lunch" seminars and directly from fund salespersons. Such promotions are consistent with the old adage “Mutual funds are sold not bought ". Fund companies use performance advertisements much more often during stock market upswings (and at RRSP time) than downswings, because they have higher returns to advertise when the stock market has been performing well. This phenomenon is very important. It means that the timing of performance ads encourages investors to make a major investing mistake: chase past returns.

Performance ads may prompt investors to buy equity funds primarily when recent stock returns have been high. This is the opposite of what investors should do- buy low, sell high .In many performance ads, the implication of continued high performance is not subtle. Statements such as "superior proven performance" or "superior risk- adjusted performance" are both vague (superior to what?) and exaggerated (is the performance repeatable or does it imply certain future returns? Such headlines touting the advertised fund’s “proven” performance are understood as saying that such past performance predicts likely future performance.

What the regulators Say

Canadian regulators have recognized the troubling tendency of mutual fund investors to chase past returns. Regulations specify how funds may calculate and present past performance in their ads. The rules also require that performance ads include a warning:

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the Fund Facts before investing. Mutual funds are not guaranteed or covered by the Canada Deposit Insurance Corporation or any other deposit insurer. Their values change frequently and past performance may not be repeated. The unit value of money market funds may not remain constant. 

The mandated warning, however, is not a sufficiently robust disclosure to convey that strong past performance is not a good predictor of strong future performance. Instead, it merely informs investors that past performance may not be repeated in future results, that returns vary, and that investors in the fund might actually lose money. Even this light warning is subverted by putting it at the bottom of the ad page in fine print, light black over grey background.

So what to do?

So, how does one select a mutual fund? Start by reading this easy to read article 5 Things to Know Before Choosing a Mutual Fund  https://retirehappy.ca/choosing-a-mutual-fund/ When it comes to choosing a mutual fund, a basic portfolio approach that is consistently implemented gives you the best chance of optimizing your returns. Asset class mix and low fund costs are key determinants of portfolio performance. Understanding your investor type and your risk tolerance/ capacity as well as knowing how to select key information from a fund profile (Fund Facts) will help you ensure that the funds in your portfolio are congruent with your financial goals and objectives.

Investors should understand that some periods of below average performance are inevitable. At such times, investors should remain disciplined in their investment approach and avoid the temptation to chase performance.

So, think twice about chasing past returns based on fund ads. It may be harmful to your financial health.

Ken Kivenko                                                                      November,2017

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