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Portfolio > Mutual Funds

SEC Loophole Lets Funds Mislead Investors on Performance: Study

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What You Need to Know

  • SEC rules allow funds to change their benchmark indexes, and about a third of funds in a study did so.
  • Some funds change indexes for legitimate reasons, but poor performers are more likely to switch and inflows rise after they do so, researchers found.
  • The behavior appears to be legal but seems to conflict with the SEC's transparency goals, researchers said.

Investors exploring mutual funds and comparing their returns to benchmark indexes may be surprised to know that funds can change their benchmark to make performance appear better than it is.

A new study, “Moving the Goalposts? Mutual Fund Benchmark Changes and Performance Manipulation,” found that some mutual funds take advantage of a loophole in U.S. Securities and Exchange Commission disclosure requirements “to provide misleading information about past performance.”

SEC rules allow funds to “freely change their benchmark indexes and, implicitly, the historical returns to which they compare their past performance,” wrote Kevin Mullally of the University of Central Florida and Andrea Rossi of the University of Arizona finance department.

“Funds exploit this loophole” by adding indexes with lower past returns or dropping indexes with higher returns, “which materially improves the appearance of their benchmark-adjusted performance,” they said.

“High-fee funds, broker-sold funds and funds experiencing poor performance and outflows are more likely to engage in this behavior,” the researchers wrote. “These funds subsequently attract additional flows despite continuing to underperform their peers.” 

Mutual fund investors base their capital allocation decisions on funds’ past performance, using relatively simple and readily available measures, the researchers noted, citing previous studies. They also cited a 2016 Federal Reserve survey indicating that while only 13% of U.S. households invested directly in the stock market, more than half invested in intermediary vehicles like mutual funds.

SEC Rule 33-6988 requires mutual funds to disclose at least one appropriate broad-based market index to which they compare their past performance, providing comparisons of their 1-, 5-, and 10-year returns to those of at least one benchmark index. 

The SEC bases the requirement on investors’ need to evaluate how much value management added by showing whether the fund outperformed or underperformed the market, the researchers noted. 

“Given this rationale, it is perhaps surprising that the rule allows funds to add and remove benchmark indexes with little justification and does not prohibit funds from comparing their past returns to those of newly-chosen index(es) rather than to the returns of the index(es) they selected at the time the returns were generated,” they wrote.

“In essence, these rules allow funds to manipulate the benchmark-adjusted performance they present to investors simply by changing their benchmark index,” they added.

The researchers studied funds’ benchmark moves by examining prospectuses downloaded from the SEC website.

They found that:

  • 1,050 out of 2,870 funds, or 36.5%, made changes to their prospectus benchmarks at least once over the 13-year sample period spanning 2006 to 2018.
  • Among funds making at least one benchmark change, the median number of changes was two per fund. 
  • Benchmark changes occurred in 6.85% of all fund-year observations. 

While funds may change benchmarks for many reasons, the researchers found that benchmark changes lead to a systematic decrease in the past benchmark returns that funds report.

“On average, funds add indexes with low past returns and drop indexes with high past returns. Similarly, many funds also add peer-based benchmarks (reflecting other funds’ average return) with low returns and drop peer-based benchmarks with low returns,” they said.

“Added stock-based and peer-based benchmarks have lower returns than those of the benchmarks that better match funds’ actual investment strategy. Finally, added benchmarks tend to have low returns both because funds choose to add benchmarks with low past style returns and because funds pick low-return benchmarks within a given style,” they said.

The data showed that funds add indexes with 2.39% lower 5-year returns than their existing benchmarks and 5.56% lower 5-year returns than the index that best matches their strategy, results that the researchers found to be highly statistically significant.” The probability of observing these results by chance is extremely low, they added.

The research said they found evidence suggesting funds revise their benchmarks based on realized rather than expected returns. For example, the returns of the added indexes are lower during the periods funds use them to benchmark performance than in the periods before or after, they wrote.

Funds that change their benchmarks receive abnormal positive inflows for the five years after the switch, representing about 10% of fund size, the researchers found. Investors who allocate additional capital to these funds are affected adversely, as funds that change benchmarks continue to generate lower returns than peer funds, they said.

‘Misleading’ Investors

“We find that mutual funds systematically and strategically change their self-designated benchmark indexes to embellish their benchmark-adjusted performance. Simply put, funds add indexes with low past returns and drop indexes with high past returns. Investors respond to these changes by allocating more capital to these funds and subsequently experience persistently low returns,” the authors concluded.

“In short, we find evidence that funds deliberately provide misleading information to investors in their SEC-mandated disclosures,” they wrote. While the behavior appears to be legal, it seems to conflict with the SEC’s stated goal to provide transparency and a clear measure of the value that a fund creates to investors, they added.

The researchers suggested that regulators consider requiring funds to compare past returns only to those of the benchmark indexes they cited when the returns were generated.

“This requirement would effectively close the existing loophole without limiting the ability of funds to make ‘legitimate’ changes to their investment strategy or benchmarks in a forward-looking sense,” the authors said.

Legitimate Reasons

Mutual fund rater Morningstar doesn’t frequently come across funds that have changed their prospectus benchmarks, strategist Robby Greengold said Friday.

Morningstar continually speaks with portfolio managers and does want to know why when a firm makes such a change, “but we’re not often having that conversation” because the team hasn’t dealt with many funds that have switched their benchmarks, he told ThinkAdvisor.

“I can feel confident in saying that this is not something that is happening … on a frequent basis,” he said.

Greengold cited legitimate reasons a fund might adopt a new benchmark index. The asset manager may be retooling the investment approach so the previous benchmark no longer is the most appropriate, for example. Or the manager may be trying to be mindful of its own costs and will change benchmarks to pay a lower licensing fee to the index provider, he said.

A Vanguard Group spokesman, responding to a request for comment about the study and the mutual fund giant’s policies on selecting and changing benchmark indexes, said via email: 

“Vanguard has developed and adheres to a multi-dimensional process to evaluate and select benchmarks for funds and ETFs. The suitability of each fund’s benchmark is based on index construction methodology, market coverage, classification criteria, rebalancing schedule, cost and other standards.

“Vanguard also regularly assesses index providers to ensure their data integrity processes and risk management practices support their ability to provide the timely, accurate and high-quality data.” 

A Schwab Asset Management representative wasn’t available to discuss the study this week, an outside spokeswoman said via email. Fidelity Investments didn’t immediately provide a comment and BlackRock declined to comment for the article.


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