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Funds Exploiting SEC Rule to Make Performance Look Better

Mutual Funds

While SEC rules typically seek to provide transparency between financial institutions and investors, a new study suggests that several mutual funds are providing misleading information to investors by exploiting a loophole in the Commission’s mutual fund disclosure rule.

Under existing SEC rules, funds can freely change their benchmark indexes and, implicitly, the historical returns to which they compare their past performance. Consequently, funds have been found to exploit this loophole by adding (dropping) indexes with lower (higher) past returns, which materially improves the appearance of their benchmark-adjusted performance, explain Kevin Mullally of the University of Central Florida, and Andrea Rossi of the University of Arizona’s Department of Finance.

In “Moving the Goalposts? Mutual Fund Benchmark Changes and Performance Manipulation,” the pair examine how prevalent this benchmark changing is in the mutual fund industry by analyzing changes to mutual funds’ self-declared benchmarks using hand-collected data from funds’ prospectuses. They also explore how these changes affect the performance reported to investors.

Past Performance

As background, the study explains that the SEC requires mutual funds to disclose at least one “appropriate” broad-based market index to which they compare their past performance. The stated rationale for this requirement is to help investors evaluate “how much value the management of the fund added by showing whether the fund outperformed or underperformed the market.”

Indeed, investors allocate capital to mutual funds based on past performance and the perception of whether a fund can “beat the market,” the study notes, adding that mutual fund companies explicitly promote their funds based on these factors, knowing that investors will respond.

Interestingly, the rule allows funds to add and remove benchmark indexes with little justification, Mullally and Rossi observe. “More importantly, and perhaps surprisingly, the rule does not prohibit funds from comparing their past returns with those of newly chosen index(es) rather than with the returns of the index(es) they selected at the time the returns were generated,” they write.  

The rule only requires funds to disclose the previous benchmark for one year after making the change; after that, the fund company can pretend that the old benchmark never existed, the pair further observe. In essence, they note, these rules allow funds to manipulate the benchmark-adjusted performance they present to investors simply by changing their benchmark index.

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

How Common?

The study finds that mutual fund benchmark changes are common—1,050 out of the 2,870 funds in their sample from 2006 to 2018 changed their benchmarks at least once. For the subsample of funds that change their benchmarks at least once, the mean number of changes is 2.27.

More important, Mullally and Rossi note, is that these changes improve funds’ benchmark-adjusted performance. In comparing the returns of the added indexes with the returns of multiple control groups, they found that funds add indexes that have lower past returns than those of any control group of indexes they construct. For example, funds add indexes with 0.83%, 2.39%, and 4.81% lower 1-, 5-, and 10-year returns as compared with their existing indexes.

“The magnitude of these differences becomes even greater if we compare the returns of the added indexes with those of the index(es) that best match the fund’s actual investment strategy,” Mullally and Rossi observe. “In short, funds appear to be opportunistically changing their benchmarks, ex-post, to improve the appearance of their performance.”

Turning to the reasons funds make these changes, the pair finds that funds with poor past performance, funds that charge higher fees, and funds that are likely sold through brokers are more likely to change their benchmarks. “These results provide further evidence that funds are making these changes strategically to attract capital from less sophisticated investors and to increase their fee revenue,” says the study.

Finally, Mullally and Rossi warn that their results indicate that investors “are fooled” by these changes. In the five-years after a benchmark change, the researchers found that funds that changed benchmarks attract $70 million more from investors than do funds that did not change their benchmarks.

Going Forward

Meanwhile, in noting that the behavior does not appear to be “technically illegal,” the pair suggests that it does seem to conflict with the SEC’s stated goal of providing investors with transparency and a clear measure of the value a fund creates.

The SEC has recently proposed simplifying funds’ disclosures to investors, but the study further suggests that new disclosure guidelines may adversely affect unsophisticated investors if enacted without additional requirements for how funds report their past performance.

As argued in the paper, Mullally and Rossi suggest that regulators should consider requiring funds to compare their past returns only with those of the benchmark indexes they cited at the time the returns were generated. “This requirement would effectively close the loophole without limiting the ability of funds to make ‘legitimate’ changes to their investment strategy or benchmarks in a forward-looking sense,” they note.