Mutual fund

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The securities industry is probably one of the most regulated in the United States. There are clear rules on what can and can’t be said in order to prevent false or misleading communications with the public.

Given the recent positive performance in the overall market, mutual fund advertisements are coming back to main stream media and trade publications.

It is common to see funds that tote their “good management” that “fare well” even in “difficult times”.

It is also common to see funds claiming to have the most awards from Lipper, Mornignstar or other rating companies that -to simplify- arrange funds by performance in a number of timeframes. For example, you’ll see that a some companies will claim to have “the most 5 star funds”, while others will claim to have beaten their “Lipper categories”.

All those claims are not illegal, in fact, every advertisement has a substantial amount of small (or tiny) print that explains the risks and expenses of the funds advertised. But those claims are worthless (and, in my opinion, unethical).  Let me explain.

Is the number of  stars an indication on how a mutual fund will perform in the future? In a word: No. Every six months Standard & Poors releases their “Persistency Scorecard”, which essentially measures how persistent are funds in their performance. Their conclusions? Most mutual funds are terrible. The “not-so-terribles” are even less than those expected by pure luck. Worse, even Morningstar published recently that their “star system” is not indicative of future returns.

So then, why mutual funds continue to advertise past performance? Because that’s where the money goes. Mutual fund companies know that investors will pour their money into “past winners” so they put millions of dollars in advertising to increase their profits while the funds are still “hot” (ie: earned 5 stars) and before they go back to 3 or 2.

Why do investors do that? Because they believe that great past performance will translate in great future performance. Advisors also sell 5 star mutual funds either because they also believe that past performance will translate to the future or because it is easier to sell a past winner (and make a commission) than to sell a loser (or a 1 star fund).

So, investors buy 5 star funds that will become 2 stars in 2 or 3 years, sell them, and buy 5 star funds again… Essentially, most investors are “buying high” and “selling low”. Precisely the opposite of what they should be doing.

So, should investors buy 2 star funds and wait until they are rated  5 stars to sell them? Not at all. In fact, the funds at the bottom are the most likely to be merged or liquidated because of their bad performance.

What investors should do instead of chasing returns and hoping they “picked right” this time, is to build a globally diversified portfolio of index funds (or structured portfolios) depending on their ability, willingness and need to take risk. By doing so, not only they will outperform the majority of active managers, but they will reduce the anxiety of looking for the next winner.