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

51 Pages Posted: 15 Oct 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 G. Gurun

University of Texas at Dallas

Multiple version iconThere are 2 versions of this paper

Date Written: October 15, 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 due to this perceived on-average outperformance. 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.

Suggested Citation

Chen, Huaizhi and Cohen, Lauren and Gurun, Umit G., Don't Take Their Word For It: The Misclassification of Bond Mutual Funds (October 15, 2020). Proceedings of Paris December 2020 Finance Meeting EUROFIDAI - ESSEC, Available at SSRN: https://ssrn.com/abstract=3711974 or http://dx.doi.org/10.2139/ssrn.3711974

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 )

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Cambridge, MA 02138
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Umit G. 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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