Beware of performance ads
Industry slipping into old habits

They're in your face, boastful, and potentially dangerous to investor returns. Worst of all, they're back. I am talking about performance ads by mutual fund companies and other product sponsors. They've had a less than favourable impact in years past, and may spark a whole new phase of an old investor mistake.

The danger

A look at past data on the performance of funds and the subsequent pattern of cash flows into and out of funds indicates a strong tendency to chase recent past performance. In 1993, many funds sported triple-digit return figures, on the heels of a speculative frenzy in junior resource exploration companies. Asia and emerging markets enjoyed a similarly steep rise in prices. Guess where investors' attention shifted to in 1994? You guessed it: aggressive resource, metals, Asian, and emerging markets funds.

Then, 1994 saw a sharp rise in interest rates, which promptly materialized in falling bond prices in February and March. This was the beginning of a yearlong bond bear. Over the subsequent fifteen months, bond and mortgage fund investors quickly cashed out more than $6.5 billion from such funds - or more than 18 percent of assets in these funds. That's more than five times higher - proportionately - than the stock fund redemptions seen over the past couple of years.

The point is that prices of financial assets tend to be cyclical. 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.

Historical impact

At my former employer, FundMonitor.com Corporation, we examined mutual fund ads in the Globe and Mail boasting of performance. This older article by Duff Young highlights the study's findings, which ended in 1998. More than 400 ads were studied. 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.

In a broader context, investors have not had a good experience in stock funds over the past ten years. I estimate that investors in Canadian, U.S., and other foreign stock funds have earned just 4.5 to 5 percent annually through the end of 2003. That's pretty awful considering both the theoretical and actual risk in these funds. So, in both a risk-adjusted and absolute context, investors have every reason to be disappointed.

But it's not so much the funds that have let people down. Rather, it's their behaviour - albeit some of this is guided by the financial advisory industry.

Now, performance ads are back, so how do we keep from repeating old mistakes? Start by studying the ads a bit more and setting realistic expectations. Easier said than done, but here's are two tips.

Tips

Ads boasting of extraordinarily high returns, like 50 percent and above, were likely achieved either in a risky asset class or with an aggressive management style. These funds and firms have the greatest potential to disappoint. But ads with somewhat lower, but still spectacular, returns have to be studied a bit more carefully.

For instance, Saxon funds have been advertising more than ever. That's the result of two factors: great performance and a bulked up ad budget (thanks to their new parent, MD Funds Management). But Saxon, and other similar firms, is no high-flyer. They manage core asset classes with a value-orientation. Hence, I wouldn't worry about people piling into Saxon today. But if you do so expecting 30+ percent returns, I guarantee disappointment will soon set in. It's just not sustainable.

Performance is obviously an important part of studying funds, but don't make decisions based on great recent performance only. I know both investors and advisors know this well - but the continuing trend of 'investors misbehaviour' suggests a reminder won't hurt.