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The cost of misclassification in mutual funds

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  • Fang, Fei
  • Parida, Sitikantha

Abstract

In March 2020, Morningstar revised its Low Carbon Designation (LCD) methodology. Before this revision, U.S. mutual funds were categorized into two groups: those meeting low-carbon thresholds (labeled as LCD funds) and those that did not (non-LCD funds), which were perceived as high-carbon funds. Crucially, many funds lacking available carbon metrics were not categorized separately from non-LCD funds, resulting in their misclassification and the mistaken perception of being high-carbon funds. The updated methodology introduced a third category—missing rating funds—to represent funds for which the LCD could not be determined. Our analysis reveals that the failure to distinguish missing rating funds from non-LCD funds resulted in approximately $21.3 billion in lost flows to these funds compared to LCD funds over the three months preceding the revision. After the change, these previously misclassified funds experienced a significant recovery, attracting approximately $15.6 billion more than non-LCD funds within three months. Our findings highlight the substantial financial consequences of fund misclassification. They also reveal that investors respond strongly to fund ratings, even when inaccurate, suggesting a preference for ratings over underlying information.

Suggested Citation

  • Fang, Fei & Parida, Sitikantha, 2025. "The cost of misclassification in mutual funds," Finance Research Letters, Elsevier, vol. 78(C).
    • Handle: RePEc:eee:finlet:v:78:y:2025:i:c:s1544612325003381
    DOI: 10.1016/j.frl.2025.107074
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    Keywords

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    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming

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