Your Funds: What fund companies do to mislead their investors

My friend Keith works for a big mutual-fund company and assumes I hate mutual funds because I "always write about the things we do wrong."

He insists fund companies don't actually do much wrong, because they follow the proscribed rules and regulations and they'd get in trouble if they violated those standards.

While he's right from a legal standpoint, he ignores the simple truth that the rules leave fund companies a lot of ways to fudge the statistics, and the meaning of the numbers. What's more, industry practices let fund companies -- or research firms -- hype red herrings, information that's attractive but not necessarily meaty and important.

If these numbers factor into your investment decisions, you may want to look at their meaning more closely:

Past performance, part I: Past performance is where a fund "tastes great" and there are no consequences of indulging. Fund executives publish fine-print warnings that past results are not a reliable indicator of what to expect going forward, but that's always below the big-type hype using those results as a big reason why you should buy a fund now.

So long as investors use past performance to frame future expectations and make it the key reason for buying a fund, management will promote a statistic that they know is bad for you.

Past performance, part II: Some funds achieve their record the old-fashioned way, through shenanigans and financial engineering. Fund companies routinely merge away their bad track records. If XYZ Growth is a laggard but XYZ Large-Cap -- run by the same management team -- has reasonable performance, the growth fund will get the ax and the strong record survives. Never mind that many investors had a lesser experience -- or that management has shown an ability to underperform -- the snapshot view looks good.

Past performance, part III: The long-term annualized average record looks good but ignores the question "What have you done for me lately?" Some funds live off past performance; they haven't been solid performers for years, but big numbers produced in the more-distant past make them look solid.

Average costs: While there is no guarantee that cheap management is good management, costs matter. That's why many investors set their cost barometer based on the average cost for the type of fund they are buying. For a stock fund, the average expense ratio is roughly 1.3 percent. It's roughly 1 percent on bond funds.

In general, investors think that "below average" is sufficient. What they don't know is that the average is skewed dramatically by the way an arithmetic average is calculated. Using a "dollar-weighted average" drops the "average" expense ratio significantly, so that the typical costs for investors in stock funds drops below 1 percent (that's good, because it means investors gravitate to low-cost funds).

Returns aren't adjusted for taxes: The fund company doesn't pay Uncle Sam, but you do. Funds tell you what they earned, when what's most important is what you get to keep.

Time-weighted performance measurement: This boils down to "your mileage may vary." Funds that have feast-or-famine performance can look good when performance is annualized or smoothed out to look at multiple years, but the real question is whether investors got what the fund claimed to deliver.

Charles A. Jaffe is senior columnist at MarketWatch. He can be reached at or at Box 70, Cohasset, MA 02025-0070.