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CELEBRITIES get accused of using plastic surgery, Botox or Photoshop to make
their faces look deceptively young all the time. A new academic study* shows
that mutual funds use similar tricks to make their returns look more
attractive.
Under American law, mutual funds that advertise past performance are required
to use set time periods of one, five and ten years. Unsurprisingly, funds tend
to advertise more heavily when their performance has been good. The industry
spent $28.5m on advertisements about their returns in 2005 but only $1.6m in
2009, after the financial crisis had laid waste to stockmarkets.
But an improvement in mutual-fund performance can come about for two reasons.
The first is strong performance in the most recent period; the second is when
bad performance drops out of the record. So a fund that has a great-looking
ten-year record might have had a stellar 2014 or a dismal 2004 that no longer
shows up in the numbers. The latter is dubbed a horizon effect , as old data
disappears from view.
Some academics are not convinced that investors should pay any attention to
past performance, since almost no fund managers consistently beat the market.
It makes even less sense for investors to buy funds because of the statistical
benefit that arises from old data dropping out of the historical comparison: it
is rather like bread that has gone stale beneath the crust. But the study finds
that investors do get fooled and divert more money to funds that benefit from
the horizon effect.
That may be because mutual-fund managers advertise such funds more heavily.
Managers are certainly familiar enough with past performance to know when a
particular fund will benefit from the horizon effect. In addition, fund
managers tend to increase the fees on funds that benefit from stale performance
numbers dropping from view, thus penalising both existing and new clients.
The study paints a picture that s not very pretty, concludes Raghavendra Rau,
one of the report s authors. The effect is not unlike a Botox operation gone
terribly wrong.
funds" by B. Phillips, K. Pukthuanthong and R. Rau.