In this post I highlight two ways in which the Mutual Fund industry may influence prospective investors, especially those who are not fully aware of what happens behind the scenes. These misleading acts are related to performance. That is, how these companies advertise their performance. To fully understand the issues we first need to understand the industry. Mutual Fund companies generally don’t offer just one fund, they typically offer dozens of funds to investors. Those funds usually span the asset class spectrum (from large cap to small cap, diverse geographic regions and diverse industry sectors). So in a given period (quarter, year, five years, etc.) some of these funds inevitably perform well (because the overall economy, or their region, or their industry has done well). What do the Mutual Fund companies do? They pick out their best performing funds and advertise those heavily. This makes them look like geniuses, and catches the eye of the average investor. That investor signs up for an account but doesn’t realize that her investments will likely be going into some of the funds that have not performed as well (and may not perform as well in future). The next time you see advertising, look at the name of the fund(s): it may be bizarrely non-mainstream. For example, you may find that the “Latin American Space Exploration Medium Term Convertible Bond Fund” returned 23% over the last three years. Such marketing draws your attention away from the fact that the firm’s American large cap and mid cap funds performed below average. The latter are funds you will likely end up holding in a typical portfolio. (By the way, I shamelessly made up that fund name – any resemblance to existing funds is purely coincidental).
Here’s the second example. We established above that inevitably, since Mutual Fund companies manage dozens of funds, some will do well while other do poorly. We know those that do well will become the “poster children” in marketing campaigns. What about those that do poorly? The simple answer is that under-performing funds are either shut down, or merged into other, better performing ones. This removes the “offending” example of poor performance from the scene. After all, if a fund is closed, the Mutual Fund company no longer has to report its results or be embarrassed by them. Have you ever received a brief notice from your Mutual Fund company, stating that one of your funds will be closed as of some date, and that your holdings in that fund will be transferred to another? To make this as smooth and unremarkable (the last thing they want is for you to remark on this and dig deeper) you may be told that for your convenience you don’t have to take any action: the transfer will take place automatically. If you’re like most investors, you view this as routine, put the message in the recycling bin, and never wonder why your fund is being closed.
The upshot: carefully examine any funds that are recommended to you. Be very skeptical of performance claims. It’s advisable to use resources at your disposal, e.g., Internet search, to read about any suggested investments.