Editor’s note: We posed the following three questions to Huaizhi Chen, University of Notre Dame; Lauren Cohen, Harvard University; and Umit Gurun, University of Texas at Dallas, the authors of "Don’t Take Their Word For It: The Misclassification of Bond Mutual Funds." Below are their responses.
What did you study?
Investors rely on external information intermediaries to lower their cost of information acquisition. While prima facie this brings up no issues, if the information that the intermediary is passing on is biased, these biases propagate throughout markets and can cause real distortions in investor behavior and market outcomes. We document precisely this in the market for fixed income mutual funds. In particular, we show that investors’ reliance on Morningstar has resulted in significant investment based on verifiably biased reports by fund managers that Morningstar simply passes on as truth.
What did you learn?
We provide the first systematic study that compares fund reported asset profiles provided by Morningstar against their actual portfolio holdings, and show evidence of significant misclassification across the universe of all bond funds. A large portion of bond funds are not passing on a realistic view of the fund’s actual holdings to Morningstar and Morningstar creates its risk classifications, and even fund ratings, based on this self-reported data. Up to 31.4% of all funds in recent years, are reported as overly safe by Morningstar. This misreporting has been not only persistent and widespread, but also appears to be strategic. We show that misclassified funds have higher average risk - and accompanying yields on their holdings - than their category peers. We also show evidence suggesting the misreporting has real impacts on investor behavior and mutual fund success. Misclassified funds reap significant real benefits from this incorrectly ascribed outperformance in terms of being able to charge higher fees, receiving “extra” undeserved Morningstar Stars within peer groups, and ultimately receiving higher flows from investors.
What advice might you have for investors given your findings?
We believe that our findings highlight that investors should take extra care – and interpret with caution – information (e.g., ratings, tacit advice, etc.) coming from information intermediaries. Ever more – along with novel types of - data are being generated, resulting in increasingly complicated modern financial markets. Given this, investors must take a more active role engaging as important partners in verifying and collecting their own data in the formation of investment theses.
The Effect of Health and Mortality on Portfolio Choice
We analyze portfolio choices of 70,000 households over a period where one in the family gets cancer. We find that a cancer diagnosis reduces risk-taking along the extensive margin. In contrast, having personal experience with cancer many years ago is not associated with the current portfolio choice. Fatal cancers change family composition. Widowhood increases the probability of a stock market exit for the widowed individual by a factor of 16 relative to non-fatal cancers. In line with theory, the relationship between widowhood and subsequent portfolio choice depends on the relative importance of the deceased's human capital.