Now ‘Past Performance’ Is an Indication of Even Less

Almost every investment brochure includes this phrase: “Past performance is no indication of future returns.”

Increasingly, however, investors will have to be on the lookout for footnotes that say past performance may not even be an accurate reflection of history.

Welcome to the confusing new world of money management, where a good investment story line can be fact or fiction.

Thanks to several recent decisions, the National Assn. of Securities Dealers and the Securities and Exchange Commission have started to change the way they deal with the track records of some investments and money managers.

In the past, the rule was that the track record belonged to the investment. That meant, for example, that if a mutual fund manager changed funds, the track record stayed with the old fund. The manager could not refer to the history in touting new offerings.

Now, however, the regulatory agencies are saying that the track record can be moved so long as the new investment is essentially the same as the old one. That means that both the fund manager and the old fund--now managed by someone new--can cash in on history.

But that’s far from all. These changes also mean that cloned mutual funds--new funds that are nearly identical to older, established investment pools--get to use the history of their sires, and that brand-new funds that have existed in other forms may now tout their history as, say, a limited partnership.

Money managers get to make history too. Recently, for example, I met a money manager from St. Louis whose impressive brochure graphically depicts the success of his market-timing investment system. The footnotes in the brochure explain that the data shown in the provocative charts actually represented the performance of the manager’s $1-million-plus personal retirement portfolio, which was managed in accordance with the program he uses for clients today.

A retirement account--in which transactions are nontaxable--is hardly the same thing as using a heavy-trade market-timing system for taxable investments. The management may be “substantially similar,” but the tax consequences, and thus the returns, aren’t.

Likewise, many mutual fund companies “incubate” funds, meaning they start with a bunch of small offerings that are not open to the general public. When a manager has shown his or her acumen or the public shows significant interest, the investment firm rolls out the fund as a new offering. (Unsuccessful incubator funds die silently.)

Until recently, the incubator fund’s history started on the day it was first offered to the public.

Now “pre-inception data”--the results the fund posted before it actually became a real, live mutual fund--can be used in advertising and prospectus materials. Thus, only the funds with better records are likely to be marketed. This is called “creation bias.”

The issue boils down to whether it is better for an investor to know the relevant history of a fund or advisor. The regulators have concluded that more information is the best route to take.

“More information is generally better, but the question is whether people will get bamboozled by the presentation of a record that is skewed to make something look better than it really is,” says Kurt Brouwer of Brouwer & Janachowski, a San Francisco investment advisor. “You have to have enough expertise to be able to evaluate that track record and see how real it is.”

And that burden is being placed squarely on the shoulders of investors.

The major mutual fund data providers--Morningstar, Lipper, Value Line, Micropal and others--are between a rock and a hard place here. On the one hand, they need to give their big clients--fund companies and retirement plan sponsors--the data they want; pre-inception data could lead to altering history.

Say the XYZ Incubator Fund posts three years of great numbers before going public. After two years, it now has a five-year history. If the data providers were to include XYZ with the five-year averages, they would change the average performance with funds that have a real five-year history.

To their credit, the data firms say they will not change averages and other historical data to reflect the pre-inception data.

*

Still, there is no guarantee from the regulators that they will stop XYZ from advertising its five-year history and doing a comparative analysis--namely, saying that it has a better-than-average record compared with all funds that have a five-year history.

“Past performance is all most people have to go on,” said Steven M. Lipper, a vice president at Lipper Analytical Services. “These changes increase the potential for confusion. By allowing for greater latitude, there is greater opportunity for abuse.”

Clearly, the regulators have opened Pandora’s box. Barry Barbash, director of the SEC investment management division, said recently in Washington that the new rules are still being shaped and that the criteria for “misleading information”--the SEC’s big standard on this track record stuff--will be reviewed on a case-by-case basis.

There will be plenty of cases. Every insurance company separate account with a solid record is now a potential mutual fund. So is every private investment pool.

And the track record of every pension fund manager or anyone who runs money someplace now has the potential to be used so long as his or her next investment pool is “substantially similar.”

Anyone who runs money knows that similarities end quickly. A small private account--like the money manager’s personal retirement plan--is not the same thing as handling big chunks of cash. Any investment pool operating under rules that do not apply to a mutual fund is not the same as a mutual fund.

Ultimately, investors may be happy with the change in the rules, finding the additional investment history helpful.

For now, however, it’s too much change too soon. Initiated just as the investment industry is moving toward simplified documents--an acknowledgment that few people read their paperwork--it opens a loophole that puts a premium on reading the fine print.

Until the standards are clear--they won’t be for a while--investors must heighten their buyer-beware sensitivity.

If you are pitched an investment or money management system that is “just now available to the public,” go immediately to the fine print. If track record plays a major part in your investment decisions, make sure that the history you are shown is real and not just “substantially similar.”

It’s your money, and you have plenty of choices out there. Don’t mess around with “new” investment techniques and offerings that are showing “old” track records.

If past performance does not accurately reflect the past, don’t risk what it might portend for the future.

*

Charles A. Jaffe, personal finance columnist at the Boston Globe, can be reached at P.O. Box 2378, Boston, MA 02107-2378.