The agency says that 30% of bond mutual funds carry more risk than advertised

The National Bureau of Economic Research issued a stark warning about bond mutual funds and risk. In a new report, NBER says that at least 30% of bond mutual funds hold riskier assets than what Morningstar reports. The agency released this warning in a report titled “Don’t Take Their Word For It: The Misclassification of Bond Mutual Funds.”

The new study says that these funds have exposed investors thanks to a “large information chasm.”

“Many funds report more investment-grade assets than are actually held in their portfolios, making these funds appear significantly less risky,” the authors write.

“This results in pervasive misclassifications across the universe of US fixed income mutual funds by Morningstar, who relies on these reported holdings. The problem is widespread- resulting in about 30% of funds being misclassified with safer profiles, when compared against their actual, publicly reported holdings. “Misclassified funds” – i.e., those that hold risky bonds, but claim to hold safer bonds– outperform the actual low-risk funds in their peer groups. “Misclassified funds” therefore receive higher Morningstar Ratings (significantly more Morningstar Stars) and higher investor flows due to this perceived outperformance.”

National Bureau of Economic Research on Bond Funds

The National Bureau of Economic Research highlights problems at the fund family level.

“Misreporting is stronger following several quarters of large negative returns, and it is strong at the fund family level,” the authors state. “We report those families that have the highest percentage of misreported funds in the sample.

The NBER team – led by Huaizhi Chen – said that the misreporting has been “persistent, widespread, and appears strategic – casting misreported funds in a significantly more positive position than in actuality.”

The team highlights Morningstart’s reliance on self-reported summary data. This data is used to build risk classifications and register fund ratings referred to as “Morningstar Stars.”

“Now this would be no issue if funds were truthfully passing on a realistic view of the fund’s actual holdings to Morningstar,” the authors note. “Unfortunately, we know that’s not the case. We provide robust and systematic evidence that funds on average report significantly safer portfolios than they actually (verifiably) hold.”

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