I’m an active academic and long-time finance professor, so I stay on top of the latest academic research in the fields of finance, especially investments. On occasion, I will provide short, easy-to-read summaries of recent and relevant research, to help you give your clients the best and most cutting-edge investment advice.

Let’s do a little bit of math. Yeah, we hate math, but this will be easy and it will be worth it. Let’s say that a mutual fund experienced the following returns over the last four quarters:

3%, 4%, 5%, -4%

The 3% return is from the most recent quarter, the 4% return is from the quarter before, and so on. So, the one-year annual holding-period return (HPR) is 8%. (More specifically, it’s 7.9% with geometric compounding.) Now let’s say another quarter goes by and the fund’s return during the most recent quarter is -2%. So, here are the fund’s returns from the last five quarters:

-2%, 3%, 4%, 5%, -4%

The annual holding-period return (HPR) for the most recent year is 10%. (More specifically, it’s 10.2% with geometric compounding). So, even though the fund experienced a 2% loss in the most recent quarter, its updated annual return is now higher than it was before because the -4% return from five quarters ago is no longer used to compute the most recent annual return. As an investor, should it matter to you if the -4% quarterly return occurred four quarters ago or five quarters ago? It probably does not. But what if this mutual fund then brags that its past year’s return is now higher than before? That’d be pretty sneaky, right? Especially given that it’s most recent quarterly return was for a loss. 

According to a recent study published in the Critical Finance Review, a top scholarly finance journal, when something like the above happens, where annual returns are improved only because of the removal of “stale” returns, mutual funds will specifically advertise this improvement in order to attract investors. And, the study finds that the dubious practice works. That is, mutual funds that specifically advertised these kinds of improved annual returns were able to attract investors and flows.

The fact that this questionable practice appears to actually work is not surprising for the following two reasons. First, investors usually don’t have the time, and also may not have the ability, to dig deep to discover that the improved annual returns is simply because of the removal of an old return. Second, mutual fund investors are well-known to chase past performance. So, when mutual fund managers advertise these kinds of improvements in annual returns, they are taking advantage of investors’ shortcomings in order to win more business. Here is a quote from the study: “Our analysis suggests that investors fail to recognize the effect of horizons on HPR calculations, allocating disproportionate wealth to funds when negative stale performance drops from the horizon.” 

Disgusted? There’s more. According to the study, mutual fund managers also used these opportunities, where updated annual returns improve only because stale returns were dropped off, to increase their fees. The study’s authors state that the most surprising finding is that mutual fund managers take advantage of investors not only to win business but also to charge them more. Here is a quote from the study: “... we show that mutual funds appear to time fee increases to coincide with periods of stale performance chasing, taking advantage of unsophisticated investors who do not appreciate the mechanical effect of time on HPRs.”

But I am not surprised. I have previously written about the questionable behaviors of mutual funds. Advisors, this is yet another reason to steer your clients away from mutual funds and into ETFs or SMAs. In the 21st century, you don’t have to be rich to be invest like the rich.

Kenneth A. Kim is chief financial strategist at EQIS.