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

Abstract

We provide evidence that bond fund managers misclassify their holdings, and that these misclassifications have a real and significant impact on investor capital flows. In particular, many funds report more investment grade assets than are actually held in their portfolios to important information intermediaries, making these funds appear significantly less risky. This results in pervasive misclassification across the universe of US fixed income mutual funds. The problem is widespread - resulting in up to 31.4% of funds being misclassified with safer profiles, when compared against their true, publicly reported holdings. “Misclassified funds” – i.e., those that hold risky bonds, but claim to hold safer bonds – appear to on-average outperform the low-risk funds in their peer groups. Within category groups, “Misclassified funds” moreover receive higher Morningstar Ratings (significantly more Morningstar Stars) and higher investor flows. However, when we correctly classify them based on their actual risk, these funds are mediocre performers. These Misclassified funds also significantly underperform precisely when junk-bonds crash in returns. Misreporting is stronger following several quarters of large negative returns.

Keywords: Misclassification, Rating, Fund flow, Fixed income, Mutual Fund

JEL Classification: G12, G11, G4, G24