Investment Style Misclassification and Mutual Fund Performance
42 Pages Posted: 20 Aug 2015 Last revised: 22 Mar 2017
Date Written: March 1, 2017
We present a novel measure to declare a magnitude of the difference between fund’s prospectus investment styles and the fund’s actual investment styles on a long- term basis. Our measure incorporates parameter uncertainty in its measurement and through a sequence of pair-wise comparisons of the style exposures determines both the number of misclassified mutual funds and their style deviation levels. We also examine the relation between the level of style deviation and fund performance on a long- term basis. Using a sample of 1,866 US equity funds over the 2003-2016 period we document that: (i) about 14% of individual funds are significantly misclassified, (ii) in the long run misclassified funds significantly underperform well-classified funds by 0.92% per year based on alpha from the Carhart model, and (iii) misclassified funds appear to be younger, smaller in size and charge higher expense ratios. We also find strong persistence in the style deviation for up to 7 years into the future, which suggests that the style deviation is not driven by fund manager’s negligence. The results of this study are substantially important for investors who follow a buy- and- hold approach rather than a short-term performance chasing strategy and suggest that maintaining a consistent style is a crucial ingredient for achieving good long-term risk-adjusted performance.
Keywords: Mutual Funds, Style Analysis, Fund performance
JEL Classification: C61, G11, G23
Suggested Citation: Suggested Citation