I have never been involved in bond fund selection so I might write about something that is well-known in the community. But when I read a paper on the misclassification of bond funds in Morningstar’s database, I was surprised how prevalent it is.
But let’s start at the beginning…
I always thought that bond funds announce their desired classification in Morningstar’s database based on their stated investment objective. Morningstar would then check the portfolio of these funds to make sure that the portfolio matches the stated strategy. If it doesn’t that would be a red flag for Morningstar analysts in their analysis of the fund’s performance and it would eventually lead to a reclassification of the fund into a more appropriate peer group.
How naïve I was.
It turns out that Morningstar relies exclusively on the fund’s reporting to classify it. Meaning that funds can underreport risky assets like high yield bonds in their portfolios and overstate the safe bonds like government bonds they own. In the ESG space we talk a lot about greenwashing that leads to misclassification of funds. This is a similar effect that I would call safewashing.
If you give funds the opportunity to make themselves look safer and less volatile than they actually are, they will of course do so. Because if they succeed, they will benefit from two effects. First, because within the fixed income space, more money is invested in lower volatility strategies these funds can hope to attract more investor money. Second, because they hold more risky portfolios than other funds in their peer group, they tend to outperform their peer group in calm markets. That in turn can lead to better fund ratings from Morningstar and other fund rating agencies at which point investor inflows into the fund will accelerate.
What the above-mentioned study did as to analyse the actual portfolio holdings of bond funds in the US that were available in the Morningstar database. They stripped out warrants, options, futures, and other derivatives and then calculated the rating distribution based on the actual holdings of the funds. They found that in this case 24% of all bond funds were misclassified. In the overwhelming majority of cases, the misclassification was towards safer bond strategies, indicating that funds underreport the risks in their portfolios.
Fund managers may argue that stripping out derivatives gives a misleading impression of the true risk of the fund, so the researchers did another analysis of the entire portfolio of the funds including derivatives, and concluded that 31% of all funds were misclassified. In other words, derivatives on average seem to be used to enhance returns rather than reduce risks in portfolios. And as the chart below shows, when it comes to misclassification, the safer a bond strategy, the more misclassified bonds can be found in the database.
Misclassification of US bond funds in Morningstar
Source: Chen et al. (2020).