The biggest lies mutual-fund companies tell

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 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.

In our recent discussion, I laid out for Keith what I considered the most misleading statistics and data points in the fund world

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

• Past performance, Part I: The candy of the mutual-fund world, 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 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.

What fund companies don't say is that they "incubate" funds, creating a bunch of new issues using house money, then only bringing the best performers public.

You get the fund "that sticks" as opposed to the one "that stinks," but you might have judged the new fund differently if you knew it was merely the best of a bad crop.

• 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 of great 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" — so that a fund with $10 billion in assets affects the average more than a fund with just $10 million in it — 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."

The typical pattern for a hot mutual fund is the assets only flow in after a period of great performance; in other words, investors tend to "buy high."

If the fund suffers thereafter and the shareholder bails out, they have sold low. Meanwhile the average performance numbers can still look pretty good.

What the fund does after your money arrives is all that matters.

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 actually got what the fund claimed to deliver.

You'll need to find independent research — Morningstar measures this — to know for sure, because fund companies never tell you.

• Manager tenure: Several studies show longtime managers have better performance than their short-term brethren.

Still, manager tenure has no effect on what happens next. Plenty of experienced managers got crushed in 2008; their experience was no cushion.

Next week: The biggest mistake fund investors make.

Chuck Jaffe is a senior columnist

at MarketWatch.

He can be reached

at cjaffe@marketwatch.com

or Box 70, Cohasset, MA 02025-0070.