RP: Hello again. The fund management industry spends a fortune on advertising. And it’s certainly effective. One of the reasons it works so well, researchers have found, is that fund management companies time their ad campaigns very carefully.
The research team wanted to find out why fund advertising fell away after the dotcom crash at the turn of the century, then picked up sharply five years later, before falling away again after the crash of 2008.
The answer is that fund houses, depending on where they’re based, are required to quote their returns over certain periods of time, typically one, three or five years. The researchers found that ad campaigns tend to begin at precisely the point when the bad quarters stop showing up in the numbers.
Raghavendra Rau: Fund X says “We’re the best fund in the last 5 years!”, and we say, “Woah. This is a four-star fund or a three-star fund.” and “Let’s give the fund money!” and that’s exactly what we find. We find a huge in-flow fund given to managers who have had increases, mechanical increases, in returns by bad quarters dropping off.
RP: This phenomenon of old data disappearing from view is called the "Horizon Effect". The danger is that it gives consumers a misleading impression.
RR: Retail investors are people like you and me. We don’t have time to go back and look at the fund performance last month or the month before. And see, "Is this the same fund? How did it do? Was the returns they project, is it driven by the fact that a new return is added on or a bad return has dropped off?” None of us have time to do that. You see the same effect in one year, three years, five years. So, returns drop off after one year, we see a flow of funds, bad return drops off after three years, we see a flow of funds, five years, we see a flow of funds. When you look at the mutual fund ad, you’ll say these are one year return, these are three years return, these are five-year returns… That’s exactly when we see the Horizon Effect.
RP: There is another discomfiting aspect to this research. Professor Rau and his colleagues also found that fund management companies tend to make use of the Horizon Effect when planning price increases.
RR: They don’t actually raise their fees, what they do is, they stop waving their fees. Because to actually raise your fees you need consent from the fund shareholders. So, when the performance is really bad, you say "Okay this quarter I’m going to wave my fees.” And when the performance improves, because bad quarters have dropped off, you say “Do you know what? I’m no longer going to wave my fees.” So, effectively, it’s an increasing fees.
RP: The lesson is to be very cautious about fund advertising. And remember, even if a fund has an impressive record over five years, that certainly doesn’t mean it’ll outperform for the next five. Until next time, goodbye.
Don’t forget to subscribe to our YouTube channel where you'll find acres of digestible investor education - no matter what you're investing for.
By subscribing, you can dip in and out and tailor your own learning programme.
Or get back to our Video Library to find more digestible content.