Ethics @ work: Lies and statistics

Outsize performance demands outsize suspicion.

I try to keep this column topical, but sometimes being topical is at the expense of some chronic business ethics problems that just never go away. Advertising of mutual funds in Israel is very near the top of my list. In Israel, mutual funds do not provide any disclaimers. In fact, they actively imply that past performance is a guarantee of future results. Some examples: "If your mutual fund returned less than X% return last year, you should call us." "We promised and we delivered." Many (but by no means all) Israeli mutual funds employ selling techniques that are extremely misleading and are, in my opinion, fraudulent. In the US, mutual funds are allowed to publicize past returns, but the Securities and Exchange Commission requires them to include a disclaimer: "Past performance is no guarantee of future results." Research shows that this disclaimer is an understatement. Past performance provides no guidance whatsoever for future results. Having a higher than average performance in one year is totally uncorrelated with having an above-average performance in subsequent years. Here are two facts that should help the consumer avoid shark bite: 1. Exhaustive research by scores of leading experts has shown that managed funds do worse on average than non-managed funds. In fact, even before management costs fund managers do no better than the market; the result is that you add insult to injury end by actually paying a manager for poor judgment. While with hindsight we find some managers who beat the market consistently, there is no evidence that this is anything but luck. Just by throwing darts, you will beat the market half the years; one-quarter of dart throwers will beat the market two years running, etc. Even if we concede that there may be some gifted managers out there, you will not find them by looking at their track record for a short period of time. 2. While returns from year-to-year are not correlated, risk is correlated. Firms with outsize returns in one year are likely to have outsize returns the following year - positive or negative. A mutual fund with a very high return in one year is almost certainly pursuing a very risky strategy that greatly increases the chance of a disastrous loss in the future. So a large positive return does not increase your chances of beating the market but does increase your chances of suffering a catastrophic loss. These well-known facts are exemplified by a study publicized this week in the Wall Street Journal. About 9% of US stock funds posted over 100% gains in the year ended March 2000. If this amazing performance was due to skill, we would expect that most of them would have above average returns in subsequent years. If it was due to luck, then we would expect about half of them to have above average returns in subsequent years. In fact, less than a quarter beat the market in the following seven years. This confirms what market professionals knew well before the year 2000: huge returns are a sign of reckless risk-taking and are among the best reasons for a retail consumer not to invest in such a fund. So even if a company is completely honest about last year's outsize returns, this is absolutely no reason for the consumer to prefer this fund and, in fact, the opposite is likely. But companies don't stop at this; many mislead consumers about the extent of their gains, as well. The two most common techniques are reporting returns before costs (of course, the consumer only reaps the after-expense return) and reporting only some funds when in fact the company has several. This is a simple variant of the race-horse tout who gives "tips" to bettors and gets a fee only if the horse wins. This is a winning strategy because a tout can promote different horses to different bettors and some horse is sure to win. (Actually, these companies are worse than touts since there is no guarantee that any fund will beat the market, though it is likely that at least one will.) Conclusion: Implying that great performance in 2006 is likely to bring great performance in 2007 is misleading and, in my opinion, fraudulent. Even dispassionate reporting of past results to a lay audience should be illegal unless accompanied by an explicit disclaimer that past results are no guarantee of future performance. That being said, there are some companies with exemplary advertising policies. (I cannot know if they actually deliver what they advertise.) Some advertise that they give personalized investment advice; such advice is valuable not because it can beat the market but because different investors have different needs regarding risk and return. One company emphasizes that they can explain the ins and outs of the market - given the widespread ignorance of the public, this is certainly a valuable service and well worth paying for. And while promising (or seeming to promise) above-average returns is fraudulent, providing protection on the downside is legitimate. For example, a fund can guarantee that there will be no loss of capital if they shave the up-side a little and such funds are actually quite popular in Europe. But common sense confirms that a fund cannot simultaneously promise to give you all the up-side and none of the down-side. I also don't mean to imply that there is no importance to advertising returns. Past returns help the consumer know under what conditions a fund succeeds and what its volatility is. This information is very valuable to a knowledgeable investor. Until regulation and enforcement catch up with this loophole in securities regulation, I think that the media need to be more proactive in accepting the kind of misleading advertising that is currently so widespread. Given the current unbridled environment, the most important thing I can do is provide basic facts to consumers. The writer is research director at the Business Ethics Center of Jerusalem (, an independent institute in the Jerusalem College of Technology.