Academics Find Misreporting on Bond Funds' Risky Assets Lead to Misclassification

A paper by a group of academics from Notre Dame university, Harvard Business School and the University of Texas at Dallas provides “robust evidence” that bond funds on average report significantly safer portfolios than they actually hold, making their funds appear less risky. According to the academics, mutual funds report holding significantly higher percentages of AAA bonds, AA bonds, and all investment grade issues than they actually hold, and often the discrepancy is egregious. Due to this misreporting, funds are then misclassified by Morningstar into safer categories and enjoy higher ratings. However, when these funds are correctly classified based on their actual risk, they were mediocre performers. The academics say such misreporting results in about 30% of funds being misclassified with safer profiles, when compared against their actual, publicly reported holdings. Misclassified funds tend to outperform the actual low-risk funds in their peer groups, receive higher Morningstar Ratings and higher investor flows due to their perceived outperformance, the authors say. Meanwhile, a report in Financial Advisor magazine says that while fund managers for the most part are on top of the requirements of the Liquidity Rule, managers of fixed-income funds are facing challenges. One portfolio manager quoted in the report said assessing liquidity for certain bonds can be a “real nightmare.” Other industry participants quoted in the article say that liquidity can be relative among specific instruments – some bonds are more liquid than others and daily market shifts can quickly change a liquidity classification.