Tuesday, November 12, 2019
As a professor, I love it when academic research is front-page news! So, I was delighted yesterday to see a piece there in the Financial Times, Academics accuse Morningstar of misclassifying bond funds (here – subscription required), on Huaizhi Chen, Lauren Cohen, and Umit G. Gurun’s recently posted SSRN article: Don’t Take Their Word For It: The Misclassification of Bond Mutual Funds (here).
The gist of the article is that in deriving its risk classifications/ratings for bond funds, Morningstar’s rating system relies upon self-reported, summary data – often misreported – from bond mutual fund managers about the percentages of funds’ assets in different risk categories (AAA, AAA, B, etc.) rather than using it to supplement the data that those same funds file quarterly with the SEC. The authors explain that assets in equity funds are generally of the same security type (for example, common stock), but that this isn’t true in the case of bond funds, which are “more bespoke and unique” with differences “in yield, duration, covenants, etc. – even across issues of the same underlying firm.” (p.2) And while equity might have about 100 positions, bond funds generally have more than 600 issues. (p.2) So, in the case of fixed income funds, the role of information intermediaries such as Morningstar is incredibly important.
The article suggests that “[t]his misreporting has been persistent, widespread, and appears strategic – casting misreporting funds in a significantly more positive position than is in actuality.” (p.1) This matters because such misclassified funds then appear to perform better than others with the same risk classification and, not surprisingly, both retail and institutional investors increase their investment in these funds. (p.3) It also increases expense ratios. (p.5)
Interestingly, the authors comment “[s]tepping back, what makes this even somewhat more surprising is that the funds actually do report holdings directly to Morningstar, and these holdings line up almost perfectly with the SEC-downloaded holdings. Thus, it is literally that Morningstar uses the Summary Reports itself (and not the other data also delivered directly to it by funds) instead of taking the extra step of calculating riskiness itself that contributes to classification.” (p. 5-6). So, did Morningstar allegedly not “tak[e] the extra step” for reasons of cost, an unfortunate oversight, or another possible explanation? Note that the FT article quotes Morningstar as saying “We stand by the accuracy of our data and analytics, and we are reaching out to the authors with an offer to help understanding the data they used and to clarify the…methodologies we employ.” Commentary on this article by Morningstar, Morningstar Stands Behind Its Fixed-Income Data and Fund Ratings, is here.
If the article’s analysis is accurate, at least some funds must have been aware of the misclassifications. If so, what (if any) related responsibility (legal or ethical) might they have in this systemic issue? If the article’s analysis is correct, I would imagine that lawsuits won’t be far behind. Stay tuned! For now, here’s the 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, and it is strong at the fund family level.