Can you trust bond fund classification?

By LARRY SWEDROE

Despite the fact that the U.S. bond market is similar in size to the equity market, there had been no study providing a systematic comparison of how mutual fund asset profiles compare to their actual holdings. Yet, investors rely on profiles like those provided by Morningstar to make investment decisions.

Morningstar “rates” each fixed income mutual fund into style boxes based on measures of risk. These, along with expenses and other proprietary measures, are used to classify and rank funds in the form of “Morningstar stars”. Morningstar star ratings have been shown to have a strong and significant impact on investor flows from both retail and institutional investors.

Don’t take their word for it

Huaizhi Chen, Lauren Cohen and Umit Gurun analysed the actual holdings of bond funds in order to determine if Morningstar was rating them consistently and correctly, or if it was relying on summaries provided by the fund families. The danger is that information from providers may contain misrepresentations.

Their October 2019 study, Don’t Take Their Word For It: The Misclassification of Bond Mutual Funds covers 1,294 unique fixed income mutual funds and the period April 2003 through June 2019. Following is a summary of their findings:

— Many funds report more investment-grade assets than are actually held in their portfolios, making these funds appear significantly less risky. The result is pervasive misclassifications by Morningstar. By relying on reported holdings, Morningstar and thus investors who rely on their ratings are fooled.

— The problem is widespread, resulting in about 30 percent of funds being misclassified with safer profiles when compared with their actual publicly reported holdings.

—Misclassified funds (funds that hold risky bonds but claim to hold safer bonds) outperform the actual low-risk funds in their peer groups. This results in higher Morningstar ratings and higher investor flows due to perceived outperformance. Misclassified funds receive an additional (unwarranted) 0.34 stars.

— Misclassification enables funds to charge higher fees —10 basis points higher than peers.

— When funds are correctly classified based on their actual risk, misclassified funds underperform peers by about one-half percent per annum. More than 100 percent of their “outperformance” was due to misclassification (not skill).

— Misclassification is widespread, rising to 33 percent of high and medium credit quality funds in 2018.

— Misclassifications are overwhelmingly one-sided: 99 percent of misstatements push ratings up to a safer category.

— Misreporting is stronger following several quarters of large negative returns, and it is strong at the fund family level. One hundred percent of certain families’ fixed income funds are misclassified into safer categories as compared to what their actual holdings imply.

— For some funds, the discrepancy is egregious. There was one example of a fund whose reported holdings of safe bonds were 100 percent, while its actual holdings of safe bonds were less than one percent.

“Persistent, widespread” misreporting

The authors concluded that Morningstar “has become overly reliant on summary metrics, leading to significant misclassification across the fund universe”.

The misreporting, they continued, “has been persistent, widespread, and appears strategic — casting misreporting funds in a significantly more positive position than is in actuality. Moreover, the misreporting has real impact on investor behaviour and mutual fund success.”

Their most surprising finding was that “funds actually do report holdings directly to Morningstar, and these holdings line up almost perfectly with the SEC-downloaded holdings. Morningstar uses the Summary Report 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.”

They noted: “Since the first quarter of 2017, Morningstar began calculating percent asset compositions directly from holdings, but as recently as August 2019, still use the surveyed compositions to place fixed income funds in style categories.”

Forewarned is forearmed.