Weigh risks, rewards before investing
My experience over 30-some years in the financial-services business tells me that most people start with performance (that is, past performance) when choosing an investment — or an investment adviser.
Are investors relying too much on past performance? Should they be provided additional information to help them understand the risks and potential rewards of the investment or investment service?
These types of questions are currently being considered by the U.S. Securities and Exchange Commission in connection with mutual funds. To help improve disclosure, the SEC asked mutual fund investors for feedback on how performance information enters into the investment decision (SEC Release No. 33-10503: “Request for Comment on Fund Retail Investor Experience and Disclosure”).
By the way, it’s not too late to send in your comments, even though we’re beyond the published cutoff date, and it might be a good exercise. Here is the link to the release: https://www.sec.gov/rules/ other/2018/33-10503.pdf.
I’ll follow up when the SEC publishes its findings, but in the meantime, it’s helpful to review what the regulators want to know.
Here is a sample:
“[Do] you use [performance] to evaluate the risk of a fund, or do you use it for some other purpose, such as to assess the skill of the investment manager?
“How could funds improve the presentation of performance information?
“Should past performance information be emphasized or deemphasized in fund disclosures?
“Should short-term performance periods (such as 1-year) be de-emphasized and longerterm performance periods be emphasized?”
These all are important questions to consider. Most important is the first: The SEC is really asking what the performance numbers tell you — how do they guide you in making a buy, sell or hold decision.
The main thing is that investors need context. That is, historical performance is good information and useful for comparing and contrasting similar investments. But it doesn’t mean that you will replicate the results after you make a purchase. There is a lot more involved. You’ll want to know what the manager is attempting to accomplish (that’s in the prospectus). You’ll also want to look back to judge whether the manager has met his or her objectives. That you’ll find in the fund’s annual report. For context, you’ll want to compare the manager to peers, which the SEC is considering making a mandatory disclosure as well. Now, you need to do some legwork on your own, using databases such as Steele Systems and Morningstar.
Getting back to the annual report, in the Management’s Discussion of Fund Performance (MDFP), you’ll find the factors that materially affected the fund’s performance, including market conditions and strategies.
The MDFP includes 10-year performance graphs comparing the fund with an appropriate index, such as the S&P 500, and a table with the fund’s average annual returns for the most recent one-, five- and 10-year periods.
The SEC believes the MDFP can help “investors understand fund performance, the strategies the fund has used, and the risks it has taken on. This can help investors make decisions about whether to buy, sell, or continue to hold fund shares.” If the regulators have this point of view, it’s probably a good idea to read the full annual report. Selfdirected investors would need to read it thoroughly, along with the prospectus, of course. Keep in mind that the prospectus tells Henry Hailey, 10, plays the online game Fortnite in the early morning hours in the basement of his Chicago home. His parents are on a quest to limit screen time for him and his brother. The boys say they understand sometimes, but also complain that they get less screen time than their friends.