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Why fund industry advertising can often mislead

And where does the 'horizon effect' come into it?

    Advertisers and fund managers can be extremely persuasive...

    Investors need to be on their guard and know the warning signs in order to avoid falling into a very common trap.

    Professor Raghavendra Rau, from Cambridge Judge Business School, highlights the tricks of the trade that you should be aware of as an investor...

    RP: Advertising can be very persuasive. Good advertisers know exactly which buttons to press. Professor Raghavendra Rau from Cambridge Judge Business School is an expert on fund industry advertising. Investors, he says, need to be on their guard.

    RR: What a lot of fund managers do is very straight forward. You test a number of strategies, say 15 different strategies, different ideas, everything. 14 ideas don’t work out, so, what do you do? You never launch these funds. The one idea that does work out, because you’ve done backtesting and all those things, that’s the idea which launches and you say, look, if we had opened this fund to you 5 years ago, you would’ve made 150%. Now we open it up because it’s such a good fund — and people give you money. Of course, what they don’t tell you is, we launched 15 funds 5 years ago, 14 of them didn’t make any money, so we’re not opening them up. This is the only one which did, purely by accident and here’s an opportunity for you to invest money.

    RP: That tactic Professor Rau has described there is just one of the tricks of the trade. Another, for instance, is the so-called horizon effect. In other words, fund houses like to advertise a fund at the right point in time, just when a particularly bad quarter drops off its three- or five-year performance record.

    RR: Personally, as an investor, because I’m aware of all these strategies, I try to be very careful in what kind of fund I invest in. It’s almost a question of saying, do you take ads for jackets or shoes seriously? You know there’s a defect, the ad is never going to tell you that it was a bad shoe or a bad jacket, right? The ad is always going to say this is a great shoe or a great jacket. So, in other words, a lot of this is caveat emptor, the buyer should beware. Being aware of these tactics is probably the first thing that investors need to keep in mind.

    RP: Finally, remember that fund houses tend not to advertise their passively managed funds. They make a much bigger profit margin on more expensive active funds. For investors, then, paying too much attention to adverts is a bad idea.

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