Don’t Take Their Word For It: The Misclassification of Bond Mutual Funds

40 Pages Posted: 1 Nov 2019 Last revised: 11 Nov 2019

See all articles by Huaizhi Chen

Huaizhi Chen

University of Notre Dame - Department of Finance

Lauren Cohen

Harvard University - Business School (HBS); National Bureau of Economic Research (NBER)

Umit Gurun

University of Texas at Dallas

Date Written: November 9, 2019

Abstract

We provide evidence that mutual fund managers misclassify their holdings, and that these misclassifications have a real and significant impact on investor capital flows. In particular, we provide the first systematic study of bond funds’ reported asset profiles to Morningstar against their actual portfolios. Many funds report more investment grade assets than are actually held in their portfolios, making these funds appear significantly less risky. This results in pervasive misclassifications across the universe of US fixed income mutual funds by Morningstar, who relies on these reported holdings. The problem is widespread- resulting in about 30% of funds being misclassified with safer profiles, when compared against their actual, publicly reported holdings. “Misclassified funds” – i.e., those that hold risky bonds, but claim to hold safer bonds– outperform the actual low-risk funds in their peer groups. “Misclassified funds” therefore receive higher Morningstar Ratings (significantly more Morningstar Stars) and higher investor flows due to this perceived outperformance. However, when we correctly classify them based on their actual risk, these funds are mediocre performers. Misreporting is stronger following several quarters of large negative returns, and it is strong at the fund family level.

Keywords: Morningstar, Mutual Fund, Misclassification, Rating, Fund Flow, Fixed Income

JEL Classification: G4, G10, G11, G24

Suggested Citation

Chen, Huaizhi and Cohen, Lauren and Gurun, Umit, Don’t Take Their Word For It: The Misclassification of Bond Mutual Funds (November 9, 2019). Available at SSRN: https://ssrn.com/abstract=3474557

Huaizhi Chen (Contact Author)

University of Notre Dame - Department of Finance ( email )

P.O. Box 399
Notre Dame, IN 46556-0399
United States

Lauren Cohen

Harvard University - Business School (HBS) ( email )

Rock Center 321
Soldiers Field
Boston, MA 02163
United States

HOME PAGE: http://www.people.hbs.edu/lcohen

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Umit Gurun

University of Texas at Dallas ( email )

2601 North Floyd Road
Richardson, TX 75083
United States

HOME PAGE: http://www.umitgurun.com

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