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Needed: Tougher SEC Disclosures

No Guarantee: New study says current SEC disclosures insufficient to protect investors from biases about 'irrelevant’ past performance

March 10, 2021

new research from USC Marshall suggest SEC guidelines are insufficient to protect investors regarding past performanceA new study published in the Journal of Public Policy & Marketing shows that mutual fund advertisements that tout past performance exploit decision-making biases on the part of potential investors. The current SEC-mandated disclosure is ineffective at mitigating these biases.

According to prior research, past performance is not only no guarantee of future success, but also “irrelevant.”

This new study shows that disclosures should state that irrelevance in order to better protect consumers, a finding with important implications for policymakers, consumer protection advocacy groups, and lay investors.

The study titled “Fooled by Success: How, Why, and When Disclosures Fail or Work in Mutual Fund Ads” was authored by Professors Joseph Johnson of the University of Miami Patti and Allan Herbert Business School; Gerard J. Tellis of the University of Southern California Marshall School of Business; and Noah Van Bergen of the University of Cincinnati Carl H. Lindner College of Business.

Mutual fund ads often emphasize positive trends of prior returns, implicitly suggesting that future performance of the funds will be similarly positive.

“Current ads may easily mislead individuals into buying stocks or mutual funds on the basis of past performance,” said Johnson. “Touting winners misleads unsuspecting investors, when future performance is not only not guaranteed, but seems unsustainable and highly unlikely.”

Research in finance shows that “winning” trends are unlikely to continue, because mutual fund managers rarely outperform market indexes over an extended period of time. This reality has prompted the SEC to mandate that such ads include a disclosure that “past performance does not guarantee future results.”

The new research reveals that the SEC’s mandated disclosure is ineffective at discouraging potential investors from “returns chasing” – buying hot rising mutual funds.  The authors find that ads featuring positive trends of past performance exploit the “hot hand bias” in investors.

“Lay investors assume that rising trends of past performance predict increasing future performance,” said Tellis.

“As a result,” added Van Bergen, “ads that include the SEC’s current mandated disclosure are just as likely to mislead lay investors as those with no warning whatsoever.” 

The authors proposed that the ineffectiveness of the SEC disclosure is the result of its weak and ambiguous wording. The SEC disclosure states that past performance “does not guarantee” future returns, but what exactly does past performance do? The researchers found that a more effective disclosure requires a stronger and clearer warning than the present one.

The study then tested a new disclosure that improves on the SEC’s current disclosure in two ways. The full wording of the new disclosure proposed by the authors is: “Scientific research has shown that mutual funds cannot perform any better than luck. So their past performance is irrelevant.” That wording is stronger and less ambiguous than the current disclosure.

“Rather than stating what past performance does not do – predict future performance – we designed a disclosure that explicitly makes a positive claim, ‘past performance is irrelevant,’” said Tellis.

Additionally, the wording appeals to source credibility by basing its content on “scientific research.”

Across several studies, the authors found that this new disclosure was substantially more effective than the SEC disclosure at reducing the hot hand bias.

The study also shed light on why the strong disclosure is more effective than the SEC disclosure. The ambiguous wording of the existing warning leads potential investors to interpret that, although past performance may not guarantee future performance, it is nevertheless a helpful indicator of future performance.

“In other words,” Van Bergen said, “the phrase that ‘past performance does not guarantee future results’ does not convey the irrelevancy of previous performance, whereas our stronger wording does.” As a result, potential investors become less reliant on past performance.

As Johnson said, “Touting winners misleads unsuspecting investors, when future performance is not only not guaranteed, but seems unsustainable and highly unlikely.”

To cite this paper:

Johnson, Joseph M., Gerard J. Tellis, and Noah VanBergen, “Fooled by Success: How, Why, and When Disclosures Fail or Work in Mutual Fund Ads,” Journal of Public Policy & Marketing, forthcoming.

Journal of Public Policy & Marketing (JPP&M) is the premier academic and professional journal that chronicles and analyzes the joint impact of marketing and governmental policies and actions on economic performance, consumer welfare, and business decisions. Written for concerned marketing scholars, policymakers, government officials, legal scholars, practicing attorneys, and executives, JPP&M examines the interface between marketing and public policy and the functioning and performance of the nation's economy.