A study by university researchers suggests the adage about horses not drinking even if you lead them to water is also true of mutual fund investors.
The authors' conclusion: A two-year-old industry rule requiring disclosure of crucial fund expense information in advertisements isn't likely to lead to wiser cost-conscious investment selections.
Nearly three-dozen study participants who viewed sample ads tended to largely ignore fund expense information, and instead focused on the ads' disclosures about past performance.
That tendency held true even among many savvier participants who went into the study knowing about the importance of expense ratios — a fund's cost of doing business expressed as a percentage of its assets. Those ongoing fees tend to be a better predictor of long-term returns than any recent strong performance, but study participants appeared to disregard cost information across the board.
"The only way we can describe it is that there is an overwhelming preference for past returns; Call it greed," said Thomas Smythe, an associate business professor at Furman University in Greenville, S.C. "Psychologically, people are absolutely focused on the return paradigm...We chase returns."
Smythe, who's also published other research on fund ads and performance, collaborated with two experts in psychology and marketing in a study being published online this month that will appear in the December print issue of the Journal of Consumer Policy.
Other independent studies have underscored the importance of considering expenses, which are a definite and easily measured drag on future returns. In contrast, funds can rarely sustain periods of strong performance for more than a couple years, as fickle markets change direction and the fund reverts to being an also-ran.
The new study is the first to examine whether a restriction on fund advertising that took effect in April 2007 is likely to achieve its goal: better-informed investors who not only have more access to fund cost information, but use that knowledge to make savvier fund choices.
The rule was adopted by the
Financial Industry Regulatory Authority, which oversees fund advertising content, while leaving broad fund industry oversight to the Securities and Exchange Commission.
FINRA's rule requires that fund ads give both sides of the story. If the ad pitches past performance, it also must make an equally prominent disclosure about the fund's expense ratio.
Smythe said the study cost less than $3,000 to run, and was funded independently through Furman University via a professorship and university grant program.
The 33 study participants were recruited from university staff and graduate students. Smythe and his collaborators from Furman and Radford universities created 18 mock print advertisements containing varying information about fictional funds' one and three-year returns, and expense ratios.
Each mock ad bore one of two brand names: that of
Fidelity Investments, an actual fund company, or Pinnacle, a fictional brand included as an experiment variable since brand can affect consumers' views of other fund attributes. Participants ranked the funds they preferred based on information in the ads.
The six funds that participants ranked highest all had strong recent performance. Some also had low costs, but performance was far and away the biggest factor affecting fund preference.
Current FINRA regulations "may not lead to more informed consumer decision-making," the study concluded. "While FINRA has taken an important step to provide information to investors, the impact, in the form of rational investment decisions, may be minimal."
One potential area for possible further research: Testing whether investors might pay more attention to costs if ads show how a fund's fees compare with funds with similar investing styles. That's an important consideration, since fees can vary widely. The current FINRA rule doesn't require disclosure of a fund's expenses compared to rival funds, offering little context for making a decision, the study said.
FINRA spokesman Herb Perone declined to comment on Tuesday, saying the agency hadn't reviewed the findings in-depth.
Brian Reid, chief economist with the fund industry organization Investment Company Institute, said study participants' emphasis on past performance over costs doesn't jibe with what happens in the real world when investors make fund choices.
ICI research has shown that lower-fee funds draw the vast majority of cash flowing in from investors, while those with high fees are more likely to see investors pull money out, Reid said.
He also questions how important ads are to investor decisions. Relatively few buy into a fund only after seeing an ad — most work with financial planners, consider input from 401(k) sponsors, or turn to independent sources to research funds, including a growing number of online fund-shopping tools.
"Real life is far more complicated than just reading an ad," Reid said. "Most people are getting some kind of advice or guidance."
But Edward O'Neal, a former Wake Forest University finance professor and fund researcher who now consults with the Securities Litigation and Consulting Group, said the new research appeared sound. Its conclusions, he said, are in line with his own experiences about investors' tendencies to ignore costs.
O'Neal, who was not involved in the research, called the FINRA rule "a small step in the right direction." But he suggested the agency may wish to expand its required fund ad disclosure that past performance doesn't guarantee future returns. His suggestion? Cautionary language stating, "High costs definitely lead to lower performance."
