Chapter 29: Mutual Funds and Individual Investors: Advertising and Behavioral Issues

Abstract

The study reviews important interactions between mutual funds and individual investors in choosing equity mutual funds. An important question is why both sophisticated and unsophisticated investors continue to invest in actively managed funds that generally underperform. Actively managed funds have histories of high levels of spending on advertising because they know it works in increasing assets under management. Fund managers have learned that investors chase past performance in the mistaken belief that the past predicts future performance. Funds further take advantage of investors by increasing advertising when current past performance is high. Advertising encourages individual investors to make fund choices in specific funds because they are generally unsophisticated, uninformed, and have low financial literacy, including a lack of knowledge of both transparent and opaque fund expenses and fees. Any persistence in high fund performance is also much more likely due to luck than portfolio manager skill. The Securities and Exchange Commission has also failed to prohibit performance advertising or to require it to be unambiguous.