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  • August 2021
  • Article
  • Journal of Finance

Don't Take Their Word for It: The Misclassification of Bond Mutual Funds

By: Huaizhi Chen, Lauren Cohen and Umit Gurun
  • Format:Print
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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. 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

Mutual Funds; Economics; Finance; Measurement and Metrics; Risk and Uncertainty; Financial Services Industry

Citation

Chen, Huaizhi, Lauren Cohen, and Umit Gurun. "Don't Take Their Word for It: The Misclassification of Bond Mutual Funds." Journal of Finance 76, no. 4 (August 2021): 1699–1730. (Winner of the Best Paper Prize at the University of Cambridge Consortium on Asset Management, 2020; Winner of the Financial Management Association Best Paper Prize in Quantitative Investments, 2020.)
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About The Author

Lauren H. Cohen

Finance
→More Publications

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