“Truth in mutual fund advertising” Jain & Wu (2000)

by vonNudge

Mutual fund investors should invest in funds that minimize fees for their desired asset allocation. Instead, most investors actually invest by buying mutual funds with past high returns. The gap between what mutual fund investors actually do and what they should do leads investors in aggregate losing many millions a year, with the industry picking up excess rents.

So how do mutual funds advertise their funds to investors? Jain and Wu show that fund companies cater to the biases of investors by advertising funds that have had very strong recent performance. But as the saying goes, “past performance does not guarantee future returns”, and indeed this was the case. In the immediate period post-advertisement, the sample of advertised funds ended up significantly underperforming their benchmarks.

The post-advertisement performance is much more representative of the true returns mutual funds are likely to receive. Most mutual funds underperform by about the amount of fees that they charge to their investors. By advertising the rare fund that gets lucky and happens to beat its benchmark, mutual funds are profiteering from the well-known and costly biases of mutual fund investors. And as Jain and Wu show, this strategy is successful in gaining large new inflows of money to the funds with high past performance.