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

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  • Huaizhi Chen
  • Lauren Cohen
  • Umit Gurun

Abstract

We provide evidence that mutual fund managers misclassify their holdings, and that these misclassifications have a real and significant impact on investor capital flows. In particular, we provide the first systematic study of bond funds’ reported asset profiles to Morningstar against their actual portfolios. Many funds report more investment grade assets than are actually held in their portfolios, making these funds appear significantly less risky. This results in pervasive misclassifications across the universe of US fixed income mutual funds by Morningstar, who relies on these reported holdings. The problem is widespread- resulting in about 30% of funds being misclassified with safer profiles, when compared against their actual, publicly reported holdings. “Misclassified funds” – i.e., those that hold risky bonds, but claim to hold safer bonds – outperform the actual low-risk funds in their peer groups. “Misclassified funds” therefore receive higher Morningstar Ratings (significantly more Morningstar Stars) and higher investor flows due to this perceived outperformance. However, when we correctly classify them based on their actual risk, these funds are mediocre performers. Misreporting is stronger following several quarters of large negative returns.

Suggested Citation

  • Huaizhi Chen & Lauren Cohen & Umit Gurun, 2019. "Don’t Take Their Word For It: The Misclassification of Bond Mutual Funds," NBER Working Papers 26423, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:26423
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    More about this item

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G4 - Financial Economics - - Behavioral Finance
    • K0 - Law and Economics - - General

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