Working Paper: NBER ID: w26423
Authors: Huaizhi Chen; Lauren Cohen; Umit Gurun
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.
Keywords: bond funds; misclassification; investor flows; Morningstar; performance
JEL Codes: G11; G12; G23; G24; G40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Misclassification of bond funds (G12) | Increased investor flows (F21) |
| Misclassified funds (G23) | Outperform correctly classified peers (C52) |
| Misclassified funds (G23) | Mediocre performance when actual risk is assessed (D80) |
| Misclassified funds significantly underperform (G41) | Junk bonds crash (G01) |
| Misclassification (J79) | Higher ratings and investor flows (G24) |