Why You Should Ignore Mutual Fund Advertisements (Part 1)

I read a lot of financial publications. For example, I count many of the industry magazines, such as Investment News, Investment Advisor, Financial Advisor, Research, and Financial Planning, as part of my weekly reading list.

I rarely read these publications for the articles about investing, however. Such articles typically consist of some asset manager purporting to write an unbiased piece, but rather promoting some new fund or back-tested investment strategy that is likely to overpromise and under deliver.

Rather, I read such magazines for the insight that they provide about improving the way that I serve my clients, manage my business, and use technology.

However, in reading through these publications it’s impossible not to notice all of the advertisements for mutual funds, ETFs, and other investment products. In fact, I’m sure the average American encounters such advertisements all the time in many of the consumer publications that they read every day.

Obviously, such advertisements pay for the publications themselves and allow the magazine to, in theory, dedicate more time to research and quality writing. At least in that regard such ads would seem as harmless as ads for any other product, in any other magazine.

Unfortunately, investment advertising, particularly for mutual funds, is a combination of half-truths and “facts” that only tell a small fraction of the whole story.

The typical mutual fund ad goes something like this:

“In a volatile market, you need professional investment management that takes advantage of market opportunities while managing risk. Our award-winning mutual funds have been recognized by Morningstar, Lipper, and Barron’s.”

The ad would likely continue by showing one or more of the company’s 4- or 5-star rated mutual funds. The ad might also promote how those funds have performed relative to their peers. For example, the ad might state “Our Market Protection Fund (YMGHX) was #3 out of 147 growth and income mutual funds over the last 5 years.”

Wow! That sure seems impressive!

So what’s wrong with such advertisements?

Well, there are three primary problems with the typical mutual fund ad:

1) Mutual fund companies don’t advertise losers (meaning they are only telling part of the story)

2) When it comes to the history of the typical mutual fund or fund manager, past performance is no guarantee of future results

3) Morningstar ratings measure past performance and do a mediocre job of predicting the future

Today we are going to talk about the first problem. I’ll cover the other two in a subsequent post.

Mutual Fund Companies Don’t Advertise Losers

Have you ever noticed that you never see an ad for a 2-star rated mutual fund? Are such funds the equivalent of the loch ness monster? Do they actually exist?

They might as well be an urban myth, since mutual fund companies do their absolute best to hide, close, or consolidate the losing funds that they run and banish their performance from public view.

The mutual fund company is more than happy, however, to promote the heck out of its winners. Meanwhile, what a particular ad isn’t telling you is all of the funds that have not done so well.

Because a mutual fund company has complete flexibility over what they advertise, they are very careful to promote the winning funds and hide the losing funds.

To illustrate, I gathered several recent ads and compared what the advertisement showed versus the complete story of that particular mutual fund company:

Mutual Fund Company A

What the ad states: The advertisement shows a list of 10 of the company’s funds, each of which has a 4- or 5-star rating.

What the ad doesn’t tell you: The company’s average rating across all its funds is exactly that: average (about 3.1). In addition, in very fine print, the ad states that the 4- and 5-star funds they list in the ad can only be accessed through a (high fee) wrap account, through a retirement plan, or by investing a minimum of $10 million.

More likely, the typical investor would end up purchasing a different share class of one of these funds which carry it an up-front commission of 5.75%. This commission would almost certainly destroy any possible future performance advantage the fund was unlikely to carry in the first place.

Mutual Fund Company B

What the ad states: “48 funds rated 4 or 5 stars by Morningstar.”

What the ad doesn’t tell you: The company had 84 mutual funds rated by Morningstar as of the date of the ad, meaning about 43% of their funds were rated 1-, 2-, or 3-stars. In addition, a quick glance at Morningstar shows that if you include all of the company’s funds together, the combined average rating is barely better than 3-stars.

Mutual Fund Company C

What the ad states: The ad touts three of company’s top funds, each with a 4- or 5-star rating over the last 3- and 5-year periods.

What the ad doesn’t tell you: Like the other two companies, Company C’s average star rating across all its funds is a pedestrian 3.1. Even worse, nearly 70% of the company’s funds are sold with a commission/load, meaning that investors who purchase such funds are almost guaranteed to underperform due to high costs.

So next time you see an investment ad of any kind, remember that if it is touting star ratings, performance, or peer rankings, it is unlikely to be telling the whole story.

Investors would be wise to avoid such data when making investment decisions and instead focus on what they can control: fees/expenses, asset allocation, tax efficiency, and overall risk.

In follow up posts, I’ll discuss why even if a fund company’s entire lineup consists of top performers or highly-rated funds, investors should be cautious.

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