Do you know what’s in your bond fund’s portfolio? A recent study finds that a surprisingly large number of funds are fudging the data. As a result, one or more of the bond mutual funds you own may be riskier than you think.
“Many funds report more investment grade assets than are actually held in their portfolios, making these funds appear significantly less risky,” report Huaizhi Chen, a finance professor at the University of Notre Dame, and two co-authors in a new study: “Don’t Take Their Word For It: The Misclassification of Bond Mutual Funds.”
The research offers “the first systematic study of bond funds’ reported asset profiles to Morningstar against their actual portfolios.” For investors who hold open-end bond funds, the paper is a wake-up call that makes for disturbing reading.
The research analyzes data starting in 2003 through this year and evaluated how Morningstar’s summaries of funds stacked up against the actual holdings of nearly 1,300 US-focused portfolios. Based on the study’s results, the offending products are running riskier fixed-income strategies than officially sanctioned.
“A large portion of bond funds are not truthfully passing on a realistic view of the fund’s actual holdings to Morningstar and Morningstar creates its important risk classifications, fund categorizations, and even fund ratings, based on this self-reported data,” Chen and company write.
Roughly 30% of all funds (and rising) in recent years, are reported as overly safe by Morningstar. This misreporting has been not only persistent and widespread, but also appears to be strategic. We show that misclassified funds have higher average risk – and accompanying yields on their holdings – than its category peers. We also show evidence suggesting the misreporting has real impacts on investor behavior and mutual fund success.
In an interview with Notre Dame News (NDN), Chen says that a number of reasons may incentivize funds to misreport holdings, such as providing higher yields. “Typically, we think of yields as compensation for risk,” he notes.
“Riskier bonds have to pay investors more yields in order to compensate for the risk. We find that, despite being classified in the same risk categories, misclassified funds have higher reported and actual yields than correctly classified funds.”
He adds that in some cases the study found that funds that are supposed to be highly rated investment-grade portfolios are in fact below-investment-grade products. “In a lot of our cases, funds designated as AAA portfolio by Morningstar are actually full of junk bonds,” Chen tells NDN. “Initially, we hope our findings prompt investment-advising vendors to change how they report data. In the long term, we hope to see better relations between data vendors, investment products such as mutual funds and consumers.”
Meantime, what’s an investor to do? Favor low-cost index funds that track well-known benchmarks. Although there’s no guarantee that an ETF or open-end index fund won’t cheat, it’s tougher to fudge results if investors can compare a fund’s risk and return profile against a transparent benchmark. Monitoring tracking error can go a long way in revealing who’s playing fast and loose with a fund’s mandate. Ditto for comparing how a fund’s trailing yield compares with the benchmark. If a fund seems to be pulling a rabbit out of the hat with a surprisingly high yield vs. expectations, that’s a warning sign.
Keep in mind, too, that active funds – particularly when the strategies are complicated – are, in theory, easier to manipulate, in part because there may not be an obvious benchmark.
It couldn’t hurt to reach out to fund companies for clarification. Can XYZ Money Management confirm that the bonds held in a given fund deserve to be there, based on the prospectus? A firm’s response (or lack thereof) could end up as one of your more revealing research efforts.