SEC considering new rules to guide fund advertising

Federal regulators are considering a new rule that would require mutual funds to use timelier figures when they advertise performance.

But critics say the rule could lead to dubious claims and encourage short-term trading.

“It will create a problem with investor expectations,” says Keith Hartstein, an executive vice president in charge of retail sales for John Hancock Funds of Boston.

“It focuses investor attention on the wrong end of the performance spectrum – the short end,” he says.

The Securities and Exchange Commission is examining whether companies touting the performance of specific funds in advertisements should be required to use returns based on monthly, rather than quarterly, data.

The commission is also mulling whether shareholders would benefit if it insisted that fund companies’ performance ads refer would-be investors to sources of even more up-to-date return information such as newspapers or websites.

Currently funds must calculate their one-, three-, five- and 10-year and “Life of Fund” returns as of the latest completed calendar quarter.

That means a June ad could boast strong returns for the periods through March 31, but ignore a sharp drop in April and May.

“We’re looking at a variety of alternatives,” says Paul Roye, director of the SEC’s division of investment management, which oversees the $7 trillion U.S. fund industry.

“The goal is to get the most current information that you can, given all the practicable constraints,” he says.

NASD Regulation, the regulatory arm of the National Association of Securities Dealers in Washington, declined to comment on any impending changes to Rule 482 of the Securities Act of 1933, which deals with the use of performance numbers in ads. NASDR enforces the SEC’s rules on fund advertising.

Mr. Roye says that the SEC is considering the rule change because it has noticed an increase in ads aggressively touting the performance of funds whose returns have dropped considerably since the most recent quarter.

“That caused us some concern,” he says. He declined to name any funds.

But using updated performance numbers won’t necessarily protect investors from potentially misleading advertising. With the stock market jumping around like a pogo stick, rolling returns are likely to vary wildly from month to month.

Consider Fidelity Investments’ $3.2 billion Select Technology Fund. At the end of January, the fund was down 25.6% for the year. By the end of February, the fund’s 12-month return plunged to minus 59.16%.

Even long-term rolling returns are prone to big shifts in a volatile market.

At the end of January, Fidelity’s Select Technology’s three- and five-year annualized returns stood at 41.03% and 30.17%, respectively. On Feb. 28, the fund’s three-year return dropped to 21.76%, while its five-year number fell to 20.47%.

An even more troubling aspect of the SEC’s proposal, say critics, is the emphasis it puts on short-term performance.

Mr. Roye disputes the notion that monthly performance numbers will leave shareholders more vulnerable to misleading ads. “The longer the gap, the more performance can vary,” he says. “At least we would be getting closer to real time.”

Mr. Roye says he hopes updated numbers won’t encourage short-term trading.

“I don’t know that using a more current number is going to change the mind of the investor who already looks at the one-year number and makes a short-term investment decision,” he says.

Many publications require fund companies to submit performance data five or six weeks before the issue date.

“If the SEC is expecting a March issue to have numbers as of February, you may not have time to meet the publication’s deadline,” says John Reilly, who oversees advertising at MFS Investment Management in Boston.

The fund industry is anxiously awaiting the SEC’s next move on the issue.

“Our feeling is that if they are going to change this, they should do it through the formal rule-making process,” says a Fidelity spokeswoman. “That allows for a fuller venting of the issue, and you end up with a better product.”

It’s unlikely, however, that the fund industry will go to war over the use of updated numbers.

To do so would almost certainly ignite a firestorm of bad publicity. Fidelity and others are already suggesting in ads that potential investors can turn to the company’s website for more-up-to-date performance data.

big funds not opposed

“I don’t think any of the larger firms in the industry are going to go down to the mat on this,” says Burton Greenwald, a fund industry consultant in Philadelphia. “It’s simply not in their interest to be viewed as something less than straight with the public.”

Washington-based Investment Company Institute, the fund industry’s biggest trade association, has not taken a formal position on the use of more-up-to-date performance figures, but spokesman John Collins says: “We are likely to be supportive of any tightening of the rules.”

Talk of a rule change comes at a pivotal time in mutual fund advertising. Fund companies pumped roughly $515 million into advertising last year, a 22% increase from the year before, according to Boston’s Financial Research Corp.

Much of the increase, says FRC analyst Kristin Adamonis, was linked to the use of performance-based ads. “Many fund companies had very strong numbers in 1999, and they could use those numbers in their 2000 advertising,” she says.

Today it’s a different story. Thanks to a precipitous drop in returns, many fund companies are shifting to so-called image ads, which tout the brand rather than a specific product.

A rule change would be the latest in the SEC’s efforts to crack down on misleading fund advertising. In January, it issued a new “truth-in-advertising” rule to prohibit the use of misleading fund names.

“It’s all part of a larger picture of the SEC trying to increase the amount of readily available information for shareholders on an equitable basis,” says Mr. Greenwald.