A ban on fund managers including historical return data?

Britain’s decision on June 23 to vote to leave the EU may have rocked markets but with final ‘Brexit’ at least two years away Brussels is still firmly in the driving seat when it comes to regulation of financial products.

With continuation of current financial passporting rules top of the City’s wish list for any post-EU settlement for the United Kingdom, the chances are that European rulings, directives and regulations will continue to have a significant influence on the management, marketing and administration of British investment advisers.

So the proposal to place a ban on fund managers including historical return data on their funds’ marketing material is no mere academic debating point but a long-term influence on the conduct of UK investment business.

The background is an attempt by European officials to provide better protection for retail fund investors. As any fan of Burton Malkiel’s ‘A Random Walk Down Wall Street’ knows past performance is no guide to future returns, so what’s to argue with? The answer is that the proposed rule does not protect investors. It will inhibit useful transparency and disclosure to clients. It will conceal exactly the kind of data that investors actually want. In other words, there is a great deal to take issue with.

First of all, fund marketing materials in the UK have long included that caveat about past performance and future profits. It would be a naïve investor who looked at the wriggling upward line of a fund’s performance and assumed that any trend would last forever. They are aware that fund strategies and managers change, that markets move and investing holds inherent risk.

Instead, any investor using a financial adviser or wealth manager would have the real value of such historical data drummed into them. It is only by looking at the history of a fund that investors, analysts and advisers can tell if the fund is meeting its objectives; how it lies compared to any benchmark; or how does one fund compare with a similar product run by a different manager? Even the basic question of whether a fund has ever made any money for investors will not be answered without a look back.

Perversely, although Euro officials want to suppress past performance data, they are insisting on a different disclosure – a spread of forecasts for future returns based on unfavourable, average or favourable performance. The algorithms and metrics used to generate these estimates are likely beyond the understanding of the average retail investor. And among financial analysts and fund managers the theory in its pure form underlying such forecasts is not as fashionable as it once was.

In the 1970s, portfolio theory which approximates potential returns for a given risk level was in ascendency. But portfolio theory assumes efficient markets and rational economic behaviour while increasing numbers of economists now say these assumptions limit the effectiveness of forecasts based on strong efficiency and rationality.

Nor do can such risk/return forecasts account for so-called Black Swan events which change everything. The 21st century has not been short of such market shocks ranging from the terrorist attack on 9/11 through the global financial crisis of 2007-2010 and of course the UK’s recent Brexit vote – all of which lead to some rational reactions but a great deal of irrational behaviour in the part of investors.

Shocks do not have to be big to have profound and unexpected effects on a fund. Take the case of Long Term Capital Management, the fund created in 1994 by John Meriwether, former bond trading boss at Salomon Brothers. Advised by Myron Scholes – co-creator of the Black-Scholes modelling technique for valuing financial instruments – LTCM went into meltdown as a result of the short-lived 1997 Asian financial crisis.

The UK’s Investment Association has tested the particular model put forward by Europe on real funds. A fund which the forecast suggested would return 0.7 per cent in an unfavourable year had in fact lost 34 per cent of its value. As the physicist Niels Bohr put it ‘Forecasts are difficult, especially about the future’.

Combine the problems with the forecasting and the wrong-headedness of taking historic data away from investors and it is no surprise that the proposed rules have gathered a unique coalition in opposition ranging from Green MEPs to professional fund management industry organisations.