Naïve investors duped by Fund Managers exploiting “stale returns”

Wednesday, March 25, 2015
by Patty Mah, Associate Director Admissions and Communications

Ever been disappointed with a product that doesn’t exactly deliver what the package claims? An upcoming research study demonstrates how mutual funds can have a similar effect by taking advantage of the naivety of investors.

In the US, mutual funds are required by law to report past performance over set periods of one, five, and ten years. This ensures that reported performance is comparable across funds and prevents funds from selecting an arbitrary period of strong performance to report.

Performance is calculated by compounding a series of monthly returns. So improvement in performance can occur in two ways. The first is strong performance in the most recent month; but of equal influence is weak performance dropping out of the horizon.  For example, an improvement in the 1-year holding period return may reflect strong performance last month or dismal performance 13 months ago dropping from the record.

Investors observe changes in reported performance and interpret it as a signal of manger ability, “chasing” mutual fund returns. It has long been questioned if investors should pay attention to past fund performance as it is rarely persistent.

The study found that investors react with equal vigour to new and end-return related performance improvements, in essence chasing performance that actually occurred 1, 5 or 10 years previously.

“Investors either don’t understand the influence of end returns on reported performance or neglect to make the effort to reference the individual returns which would allow them to distinguish the cause of improved performance,” states co-author Blake Phillips.

Professors Pukthuanthong, Rau, and Phillips’s paper, Past performance may be an illusion: Performance, flows, and fees in mutual funds will appear in the forthcoming 2017 annual issue of Critical Finance Review and won the Outstanding Paper in Investments Award at the 2014 Southern Finance Association Meetings last November.

The study also found opportunistic behaviour by fund managers who cater to and exploit investors who are unable to distinguish the nuances of fund performance reporting.

“Mutual funds exploit this naivety or inattention by preferentially advertising end return related improvements in performance. Fund managers take advantage of increased demand by inattentive investors by increasing fees, harming both new and old investors.”

The study examines US mutual funds between the period of 1992 to 2010. Most mutual fund investors are individuals who are overwhelmed by the volume of information available to aid in fund selection. It is natural that they gravitate to information that is presented in a salient form which they perceive to be easily understood. In the instance of reported performance, important nuances impede accurate interpretation by investors, making them potentially misleading.

Professor Phillips joined the University of Waterloo in 2009 after completing his PhD in finance at the University of Alberta. Prof. Phillips currently holds the PricewaterhouseCoopers Teaching Fellowship and teaches finance to undergraduate students at the School.

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