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

65 Pages Posted: 1 Nov 2019 Last revised: 11 Aug 2020

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: April 5, 2020

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

Suggested Citation

Chen, Huaizhi and Cohen, Lauren and Gurun, Umit, Don’t Take Their Word For It: The Misclassification of Bond Mutual Funds (April 5, 2020). Available at SSRN: https://ssrn.com/abstract=3474557 or http://dx.doi.org/10.2139/ssrn.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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