What’s Significance of New Ad Rules on Funds?
You’re anxious to choose a high-performing mutual fund, but you’re stumped by this type of question:
When three funds advertise that they’re No. 1 in their class, and it’s the same class, which do you believe?
Until recently, the answer was: all of them. That’s because mutual fund companies had few advertising guidelines that forced apples-to-apples comparisons.
However, the Securities and Exchange Commission earlier this month approved new truth-in-advertising regulations that change all that. The rules set standard guidelines for how fund companies can advertise their rankings, among other things. Rankings have proliferated over the past two years as mutual funds have soared in popularity.
Here are some answers to questions about the regulations and how you can use fund rankings to choose an investment.
Q. How will the new rules help me?
A. The rules say that if an investment company chooses to advertise its ranking, it must disclose who did the ranking and the criteria used. It must also disclose the time frame--for example, were the funds ranked according to quarterly, annual or semiannual performance? It must also include how the advertised fund fared over one-, five- and 10-year periods, if it has been in business long enough.
If the ranking consists of symbols, such as stars or checks, the fund company must say in the advertisement what they mean. For instance, a three-star ranking by Morningstar Mutual Funds, a noted Chicago-based fund-rating service, may sound good unless you know that three stars means the fund scored in the middle 35% of all funds ranked--better than 32.5% of the industry but worse than 32.5% of it, based on performance and risk.
Investment companies cannot advertise a ranking put out by a related company. For instance, XYZ Mutual Funds cannot rank its own five funds, rating them 1 through 5, and advertise these rankings. And it cannot advertise how it rates when ranked only by size.
Finally, if accounting for sales charges and fees would affect the ranking, this fact must be disclosed.
Q. Why were the rules necessary?
A. When new fund rankings come out, investors begin to pour money into the top-rated funds. But many of the rankings that have been published in fund advertisements have been misleading.
For instance, Los Angeles-based Pilgrim Group ran an advertisement last year that gave the impression that its funds ranked No. 1 through No. 5 in 1992 performance. In fact, says Don Phillips, publisher of Morningstar, none of the funds ranked in the top 100 for industry performance. Pilgrim could make the claim by using a plethora of different rankings, sliced into narrow investment categories. But the only disclosure of this fact came in a footnote that said funds were ranked “in their category.”
“That Pilgrim could twist its often-poor performance record to create marketing material that makes it look like the industry’s most-successful manager presents an important lesson in the use and abuse of statistics in the fund industry today,” Phillips wrote in an article about the ad, titled “Lies, Damn Lies, and Fund Advertisements.”
Pilgrim General Counsel Theodore J. Cohen says the company does not believe its advertisement was misleading but welcomes the National Assn. of Securities Dealers’ advertising guidelines.
Meanwhile, Templeton Funds likes to trumpet the fact that it has the top-ranked global fund over the past 30 years. It’s also the only U.S. global fund with a 30-year history.
In the future, advertisements noting this 30-year ranking will also note how Templeton’s Growth Fund has fared over periods when there was competition. In the one-year period ended June 30, it ranked 21st of 75 funds; it was first of 25 funds during the five years ended June 30.
Q. When do the new advertising rules go into effect and who enforces them?
A. The NASD will begin to review fund advertisements immediately to see if they comply with the new regulations, which technically are already in effect.
However, an NASD spokesperson says it will take some time--probably three to six months--before all fund companies are in compliance. After that, any fund company that breaks the rules can be fined or kicked out of the NASD, which would bar the investment company from selling its shares to the public.
Q. Are rankings a good way to choose a mutual fund?
A. Looking at how a particular fund has ranked over several periods--importantly, the one-, five- and 10-year periods that now must be included in advertisements--is a good way to start winnowing the choices. With more than 5,000 funds, you could save time and energy by immediately excluding consistently poor performers.
Once that initial screening is done, however, these rankings become less important. Past returns are not a good indication of future performance. Indeed, a stunning short-term performance often indicates that the fund is taking big risks, and you are just as likely to lose big as you are to gain.
Q. So what are performance statistics good for?
A. They’re good at indicating volatility, which is the overall price swings both up and down. Volatility is an indication of risk. And if that’s important to you--as it should be--look at annual performance for each of the last several years, as well as the average performance statistics that would be noted in ads.
Q. What other factors should I consider when choosing a mutual fund?
A. Consider whether the fund’s investment objectives mesh with yours, the experience and integrity of the fund manager, whether there are restrictions on cashing out or transferring your funds, and any other issues that may make investing in this particular fund more or less convenient for you personally, such as local offices or toll-free phone numbers.
