Millions of investors put money for retirement into mutual funds selected on the basis of “SEC total returns” and the name of the fund.

For example, many investors are likely to chose “XYZ Long-Term Nest Egg Fund” with SEC 10-year total returns of 8%, over “ABC Fund” with total returns of 5% in the same period.

In the [1] When Performance Is An Issue: The SEC vs. Ad Claims“, Charles J. Zangara questions statistics used in mutual fund promotion:

“If an investor sees that a fund has had fairly stable average annual returns at the 10-, five- and one-year periods, isn’t it reasonable for that investor to conclude that those stable returns are likely to continue into the future?”

“What’s missing from the information is the measure of risk involved in achieving such performance.”

Most people do not read fund prospectuses. They make selections based almost solely on total returns in advertisements or on the Internet. Many 401(k) investors never see a prospectus at all.

Few investors heed the SEC-mandated disclaimer, “Past Performance Is Not Indicative of Future Results”.

Investor Confidence and the Flow of Funds

If, in coming years, millions of investors discover that SEC total returns have been misleading and systematically overstated and that, because of this, their savings have fallen far short of their retirement goals, a long-term modification in investment behavior may follow.

This may significantly alter capital flows, damage SEC credibility and lead to a restructuring of the mutual fund industry.

The importance of the use of total returns numbers in mutual fund marketing can hardly be over-stated.

One might say that total returns claims are the mother’s milk on which the [2] Common Stock Legend has grown and thrived.

Without the ability to tout total returns, fund marketers would be in a tight spot. Equity fund sales might languish.

Certainly, the motivation behind the [3] stock buyback-options movement would change.

Language That Misleads

In English, the word “return” connotes income, profits from sales, or earnings that are paid, delivered, rightfully rendered, handed over, or otherwise passed on to the investor.

Black’s Law Dictionary defines return as “profit on sale, or income from investments”.

Key elements in the common understanding of return on investment are:

1. Profits from sales or income that are, in fact, realized; and
2. Profits that are actually paid and delivered to the investor.

Since the prospectus is written in English and since the SEC has a responsibility to ensure that investors will not be misled by numbers that bear its label, the average investor might reasonably understand that a fund advertising an 8% SEC total return in the last year would have actually paid-out $800 on a $10,000 investment.

The implication of “return” is that:

• The fund had a real profit from buying and selling investments or from dividends and other income.

• These profits were actually delivered to the investor during the period.

This is not at all what happens with “SEC total return”.

What “SEC Total Returns” Means

What is meant by “SEC Total Returns” is defined in SEC Rule 482 and Form N1-A. although most investors will never find this definition.

(It is no longer required that the definition be included in the prospectus —under the assumption that investors don’t read prospectuses anyway.)

Basically, the SEC Total Return for mutual fund ABC in 2005 is defined as the difference between the net asset value of fund quotas on January 1, 2020 and December 31, 2020, disregarding sales commissions on entry or exit, and adjusting for cash dividends. The assumption is that the investor bought the fund on January 1st, reinvested all dividends, and sold out at net asset value on December 31st. A similar calculation is made over 5-year and 10-year periods.

In other words, the element of actual payout is entirely missing in the SEC definition of total returns, which is just fine with mutual fund marketers.

Take the following example:

Fund A: Net asset value per share rises from $100 on January 1, 2020 to $108 on December 31, 2020, and then falls back to $100 on January 1, 2020. The SEC total return on this fund is 8%.

Fund B: Net asset value per shares stays at $100 from January 1, 2020 through January 1, 2020, but the fund pays a cash dividend of $8 per share on December 31, 2020. The SEC total return on this fund is 8%.

From January 1, 2020 to January 1, 2020, an investor in Fund A would have gained absolutely nothing, while an investor in Fund B would have earned 8% that he could spend on wine, women, and song.

The flaw in the SEC definition of total return is exposed for all to see: transitory, unrealized capital gains are added to dividends that are actually distributed to investors.

A Misleading Disclaimer?

Even the SEC-mandated disclaimer (prominent, in bold-face type) is, in itself, misleading:

“PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.”

This disclaimer implies that SEC total returns measure “performance” — presumably that of the fund, or the fund manager.

Black’s Law Dictionary defines ‘performance’ as, “The fulfillment or accomplishment of a promise, contract, or other obligation according to its terms.”

Regular dictionary definitions of ‘performance’ include: “an accomplishment”, and “the effectiveness in which somebody does a job”.

Clearly the implication is that SEC total return figures are intended to show how well the fund manager has ‘performed’, reflecting the manager’s skill, intelligence, and professional competence.

In fact, because of the inclusion of unrealized capital gains in SEC total returns, this figure is an extremely misleading indicator of management performance, because:

• In most cases, the major component in changes in stock prices is covariance with the general market. In other words, when the stock market goes up, it would be misleading for a fund manager to claim credit for a general rise in prices of stocks in the portfolio.

• The critical decisions in ‘achieving’ the SEC total return figures are made not by the fund manager, but by the investor, who would have had to decide to buy the stock on January 1st and to sell on December 31st. If the investor had bought and sold on any other days, the total returns figure would be different. And, if the investor did not sell at all (which is usually the case) the SEC total returns may have evaporated entirely by the time the investor sees the mutual fund advertisement.

The SEC Dances to Fund Managers’ Music

For several generations, the SEC has been putting out rules purporting to protect investors interests in the marketing of mutual funds.

The SEC procedure for rule making has become by now an ancient ritual, well understood by the market Druids that take part in the ceremony.

The first step is for someone in the SEC to come up with the idea for a rule that will seemingly protect investors and make the SEC look good.

This idea is then, over many months, drafted into a proposed rule, with a lengthy justification, history of past rule changes, and copious legal footnotes.

The proposed rule is then ‘put out for comments’. Over the next months, hundreds or thousands of comments are received, mostly from people in the industry intent on removing any provisions that are to their disadvantage. To advance its point of view, industry comments are supported by legal opinions, accounting analyses, and academic suggestions — all paid for by those that would be regulated. Often, political arm-twisting comes into play.

Finally, the rule is redrafted, approved by the SEC commissioners, and published. The final result is almost always something that the market can live with and even thrive on.

What ‘SEC Honest Returns’ Figures Would Look Like

Let us imagine that the SEC decided to require fund marketers to include information on ‘total returns’ that would not mislead investors and issued a new rule, mandating that statistics be published in this form:

Fund Name	2005 Dividends	2005 Variation in NAV
XYZ Long-Term Nest Egg Fund	0%	8%
ABC Fund	5%	0%

With this disclaimer:

THESE STATISTICS ARE NOT INDICATIVE OF FUTURE RESULTS

By separating temporary variations in net asset value from cash dividends, investors would have a less biased basis on which to select funds. In the example, it is likely that the ABC Fund would attract more savings than under the current ‘SEC total returns’ method.

The chances of the SEC actually adopting such investor-favorable rules are, of course, close to nil.

Total Returns: The Bigger Picture

The misuse of “total returns” effects the capital market beyond the marketing efforts of mutual funds.

As described in the article, “[4] Are GAO Projected Returns on Equity Reasonable?“, the use of consensus figures for projected total returns for the equity market can lead to serious errors in government estimates of the retirement needs of citizens.

Millions of investors input estimated future investment returns into ‘retirement planners’ on the Internet and in programs like Quicken, based on consensus ‘total return’ figures for equities.

As the next picture suggests, total returns are seen by investors as a solid gold bar, when, in fact, the largest portion is actually smoke.

About 80% of historical total returns for US equities consists of capital gains — returns that are not dependent upon issuer performance, but rather on the willingness of investors to buy stocks from other investors at ever higher prices.

Only about 20% of equity total returns represent hard cash — dividends earned and paid by corporate management.

If most investors ever come to see equity total returns in a true light — revealing the 80% smoke component — capital flows will shift and savings plans may become more prudent.

Until then, we can count on the SEC to do its part in misleading the public.