How Mutual Funds Mislead Investors
New research shows that mutual funds routinely select the benchmark that provides the greatest degree of outperformance. They even switch benchmarks if a different one will boost their performance numbers.
Advisors know that the SEC (Rule 33-6988) requires mutual funds to disclose an “appropriate” broad-based stock market index to which they benchmark their performance. Specifically, funds are required to compare their past one-, five-, and 10-year performance to that of a benchmark index they choose.
They are likely to choose the benchmark that is easiest to beat.
For example, it is well known that due to problems of front-running changes to the index, the Russell 2000 is a poor choice for an index fund to replicate, but a good choice as a benchmark for an active fund. Over the period January 1994-June 2021, the Russell 2000 returned just 9.76%, well below the 11.2% return of the S&P SmallCap 600, the 11.7% return of the CRSP 6-10 Small Cap Index, and the 11.3% return of the MSCI U.S. Small Cap 1750 Index.
Another issue, one that investors are likely unaware of, is that, surprisingly, the SEC allows funds to change their benchmarks with little scrutiny or justification and “backdate” their performance relative to an index with a lower past return. Kevin Mullally and Andrea Rossi, authors of the July 2021 study, “Benchmark Backdating in Mutual Funds,” analyzed whether fund sponsors took advantage of this flexibility to mislead investors. Their data sample covered actively managed funds1 over the 13-year period 2006-2018. Following is a summary of their findings:
- In 454 out of 766 benchmark additions (59%), the benchmark the fund chose was in a style that was not the most reflective of its investment strategy. For these mismatched cases, funds chose to add styles with benchmark returns that were 1.39%, 6.51% and 8.83% lower than those of the best-matched style over the past one-, five- and 10-year periods, respectively.
- Funds added indices with, on average, 2.21% and 6.12% lower five- and 10-year returns than those they currently reported. The differences were statistically significant at the 1% confidence level.
- Funds deleted indices with, on average, five-year and 10-year past returns that were 1.53% and 7.08% higher than the ones they retained. The differences were significant at the 1% confidence level.
- Funds added (dropped) indices with lower (higher) past returns, improving the appearance of their past relative performance.
- To improve the appearance of their relative performance to attract more capital, funds with lower past performance and lower past flows were more likely to change their benchmarks.
- Funds that changed their benchmarks were also more likely to inflate their end-of-period returns and had less sophisticated clienteles. Specifically, funds that changed their benchmarks engaged in more “portfolio pumping” (purchasing large amounts of shares in existing positions shortly before the end of the reporting period to inflate prices and returns) and were more likely to be sold by brokers (research has shown that broker-sold funds have less sophisticated investors).
Mullally and Rossi found that funds strategically changed their benchmarks to improve the appearance of their relative performance. They concluded: “Our findings suggest that the information some funds present to investors about their relative performance does not appear to be reliable.” Sadly, demonstrating their naivete, investors rewarded funds for backdating their past performance – funds that changed their benchmarks received positive abnormal flows in the next five years. Forewarned is forearmed.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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1They defined "actively managed" as any fund other than an index fund, and excluded sector funds and balanced funds.