Investors are inundated with them: Performance ads for actively managed mutual funds. These marketing pitches feature high historical returns and trumpet strong performance.

Fund firms pay to run these ads for the simple reason that they work. Investors flock to funds that have performed well in the past - especially to those that are advertised as such. In fact, studies show that past returns may be the primary factor investors consider when

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choosing among funds.

Mutual fund companies benefit from performance ads because, along with investors, they bring in management fees in direct proportion to the amount of assets gathered.

For investors, the benefits are doubtful. Numerous studies have found little evidence that investing in funds that have performed well in the past helps investors ferret out those that will do well in the future. (For background reading, see How's Your Mutual Fund Really Doing?)

The limited value of using past returns as an indicator or future performance has not escaped the Securities and Exchange Commission. In fact, the financial watchdog purports to "help investors understand the limitations of past-performance data" by requiring fund ads touting historical returns to include a warning. It states that "past performance does not guarantee future results" and that investors could lose money in the fund being promoted.

This raises the question of whether the SEC's warning fulfills its intended role. Molly Mercer, an accounting professor at Arizona State University, my Wake Forest Law School colleague Alan Palmiter and I conducted a study to find out.

Participants were each shown one version of a performance ad for an equity fund that had outperformed its peers in the past. After reading the ad, participants were asked about their propensity to invest in the fund and about their expectations regarding its future returns. Some participants viewed a version of the ad containing the SEC's warning. Others were shown a version that was identical, except that it had no warning.

We found that the SEC's warning is completely ineffective. Participants who saw the ad with the warning were just as likely to invest in the fund, and had the same expectations regarding its future returns, as participants who saw the ad without the warning.

The warning's ineffectiveness is not surprising, given its weak language. It only warns that high past returns do not guarantee high future returns and that investors in the fund could lose money. Virtually all investors knew this even before the recent financial crisis battered fund returns.

What the warning fails to clearly convey is that high past returns are a poor predictor of high future returns. Ironically the warning could even be read as encouraging investors to chase high past returns. Stating that "past performance does not guarantee future results" arguably implies that there is a positive relationship between high past returns and high future returns - just not a guaranteed one.

To see if a stronger warning might be more effective, we showed other participants a version of the ad that contained a warning conveying the lack of a relationship between high past and future returns:

"Do not expect the fund's quoted past performance to continue in the future. Studies show that mutual funds that have outperformed their peers in the past generally do not outperform them in the future. Strong past performance is often a matter of chance."

In contrast to the SEC's warning, this stronger one did affect behavior. Participants who viewed the ad with this stronger warning were considerably less likely to invest in the fund and had lower expectations regarding its future returns. By some measures these participants behaved like participants who viewed an ad with no performance data whatsoever. In other words, they almost completely disregarded the advertised past returns.

Reading a mutual fund ad as part of a study is, of course, not the same as seeing it in the real world. We asked participants to read an ad and immediately answer questions about their reaction. In the real world, people often come across performance ads in magazines and newspapers; no one asks them to focus on the ads and make an immediate investment decision. Participants in our experiment probably read the ad more closely than investors normally do.

This difference has two important implications for interpreting our study's results. First, the study's results may overstate the impact of the strong warning. If study participants read the ad more closely than usual, they would be more likely to read the strong warning than would the typical investor. Thus, the strong warning might have a smaller impact in the real world than in the study.
Second, the nature of the study makes the apparent impotence of the SEC's warning even more remarkable. Give that it had no impact on people who focused on the ad, it almost certainly has no impact on the typical investor, who is likely to read it more casually, and who might only skim, or entirely skip, the warning near the bottom of the ad.

If the SEC is truly committed to preventing the mutual fund industry from enticing investors into chasing past returns, it should design a warning that better informs investors of the futility of this chase.

The study mentioned above will be published in the September 2010 issue of the Journal of Empirical Legal Studies. A draft is available here.

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