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Don’t Take Their Word for It: The Misclassification of Bond Mutual Funds
- clevergadget 7y agoThis is the article I wanted informed comments on the most
- metalliqaz 7y agoI cannot provide a well informed comment, but I can offer this: I am not surprised at all that fund managers are slimy and dishonest.
- Maarten88 7y ago> slimy and dishonest Wouldn't this rise to the level of fraudulent and thus criminal?
- corey_moncure 7y agoIt's only illegal if you get caught, and then only if the fine is greater than the booty you got swindling honest people out of their money.
- jacquesm 7y agoYou really should add that /s.
- jjoonathan 7y agoWhy?
- rjkennedy98 7y agoTell me the difference between stupid and illegal and I'll have my wife's brother arrested. - Big Short
- sailfast 7y agoIf you have all of the "invest at your own risk" language in the fine print, you provide complete information about the investment, and then the user does not read the prospectus because it's too long / esoteric I'm not sure it gets to that level. The fact that these ratings have been assumed to be a reliable proxy for risk in the market (to the point that people automate based on it) is likely the bigger issue here and the larger cause of the systemic risk of incorrect ratings.
- JackFr 7y agoBecause to some extent the 'risk profile' is both aspirational and out of your hands. You can say 90% of your fund is investment grade, and S&P come in and downgrade a large holding of yours (or upgrade one).
- MR4D 7y agoI work with fund managers on a frequent basis. They all have a requirement to sell when an investment crosses certain risk boundaries (such as ratings downgrades). Sure, some funds have a "go anywhere" IPS, but ratings downgrades often causes a flurry of asset sales. If you say your holdings are 90% IG, and then after a downgrade they are only 70% IG, then you have two options: #1 - sell the downgraded assets to bring it back into compliance, or; #2, if you are within your funds stated IPS, then you have to restate the number as 70%, and have to remove all literature that references the 90% number. IG = Investment Grade IPS = Investment Policy Statement
- mrfredward 7y ago>I cannot provide a well informed comment, but I can offer this: I am not surprised at all that fund managers are slimy and dishonest. And that explains why this article is on the front page of HN...not because the methods are accurate, but because the conclusion aligns with what people believe going in. Fund managers very likely are slimy, but this paper is too flawed to prove anything. Read the rebuttal from Morningstar. In the paper Morningstar's data is being assumed true while the bond funds are being criticized, so when Morningstar comes out and says that their data has a pessimistic bias, and the bonds funds ratings reflect more complete information, it seems pretty damning for the paper's assumptions.
- metalliqaz 7y agoAnd you don't see any problem with the ratings agency having "incomplete" information when they try to evaluate risk?
- MR4D 7y agoBy definition, you cannot have complete information or you wouldn't have risk. Maybe you are trying to say something else?
- metalliqaz 7y agoYou can't know the future, but you can at least know exactly what is in the fund you are evaluating.
- MR4D 7y agoNot really. Reporting requirements don’t require daily reporting for mutual funds. So you only have quarterly resolution.
- thedudeabides5 7y agoThink of Morningstar like Uber, and the individual funds as individual drivers. Drivers have an incentive to lie about their hours or their insurance (to maximize profits) and Uber/Morningstar can try to force them to be honest, but in the end only so much. Individual funds are returns maximizing, and if they can convince Morningstar (or their ultimate investors) that they are making more return not for taking more risk, but through skill, they will attract assets and make more money. Thus it's explicitly in the fund managers interest to try to maximize return, while minimizing perceived risk. One way of doing that is through purchasing securities which are 'stamped' by a third party as less risky then they are (subprime being the classic example here). Morningstar can try to structure them into reporting their portfolio to avoid this, but that reporting system can always be gamed. Meaning, ultimately like with all investing, if you just trust the passive allocator/machine to make decisions for you based on overly simple or gamable rules...it will end in tears.
- Alekanekelo 7y agoMorningstar published a response to this paper [0]. [0] https://www.morningstar.com/learn/bond-ratings-integrity https://www.morningstar.com/learn/bond-ratings-integrity
- deleted 7y ago[deleted]
- jawns 7y agoThat's quite a response! It sounds as if the authors of the paper would have done well to verify some of their factual assumptions with Morningstar prior to publication. Some key points from the response: On the apparent discrepancy between Morningstar's data and self-reported data: > Because Morningstar’s proprietary methodology for calculating Average Credit Quality particularly penalizes unrated holdings by assigning them a low rating (B or BB), it is not surprising that the authors would find Morningstar’s calculated data to produce a lower average credit quality than self-reported data. When we control for not-rated holdings, we do not find a similar pattern. How category classification is assigned: > Throughout the paper, the authors conflate where a fund lands in the Fixed-Income Style Box with its Morningstar Category. In reality, Morningstar’s Fixed-Income Style Box assignment and Morningstar Categories are distinct. Morningstar does not use a fund’s Morningstar Fixed-Income Style Box assignment to determine its category classification. How star rating is assigned: > A fund’s star rating is calculated based on past performance relative to peers in its Morningstar Category – rather than relative to funds that share its Fixed-Income Style Box placement, as described above.
- frgtpsswrdlame 7y agoHmm, I find this hard to square with Table 2 in the paper. That table illustrates consistent growth in the number of misclassified funds. If, as Morningstar alleges, the difference is in controlling for unrated bonds, that still doesn't close the door to deliberate manipulation on the fund side and misreporting on Morningstar's part. For example they say: >Because Morningstar’s proprietary methodology for calculating Average Credit Quality particularly penalizes unrated holdings by assigning them a low rating (B or BB) But if I'm the manager of an investment grade fund, why wouldn't I sneak in some crap quality, high yield, unrated bonds? Morningstar will still rate them within the investment grade universe when they might actually be much lower quality. Then all the same problems that the paper alleges arise, my 'unrated' but basically high yield bonds give me good yield and performance numbers and I get a good Morningstar rating and people flock to buy it and I get a nice tidy bonus at the end of the year.
- deleted 7y ago[deleted]
- XnoiVeX 7y agoMany individual investors have stayed away from mutual funds for quite some time now. There are better ways to invest your money imo. If the high expense ratios, hidden load charges, and diluted returns were not discouraging enough, this will help firm up that decision.
- trailrunner46 7y agoWhile its true there are alternatives now, mutual funds do sometimes have a place (there are some pretty low cost ones that cover certain areas of the market where there isnt a low cost ETF to do the same). I would say pick an area of the market you want to invest in then compare across ways to access that market, mutual funds should be in that comparison still as often times it still makes sense.
- alexhutcheson 7y ago> If the high expense ratios, hidden load charges, and diluted returns were not discouraging enough, this will help firm up that decision. None of these things are true for Vanguard mutual funds, and there are some asset classes (muni bonds, money market funds, etc.) that Vanguard only makes available as mutual funds and not as ETFs.
- trailrunner46 7y agoAs someone who has spent a lot of time in the Fixed Income world of finance I think it's great to see a paper where the researchers spend time and energy looking at the methodology a major player in the space such as morningstar is using. The easiest way to improve your returns in corporate credit is to buy lower rated (riskier) bonds as they are more equity (stock) like since you have a larger component of default risk baked into the security price. Over the long term the lower rated bonds will return more but will do so at higher risk. If you can convince morningstar which puts managers into discreet buckets to put your fund in a bucket that is safer than your actual bonds reflect, you now appear to have more return than your peers (although in reality its just because you have more risk). The lack of accurate risk (reflected by the average bond ratings of your holdings) is what is really at the core of this argument. The researchers joined together some pretty commonly used datasets in the industry (probably what I would use if I were to do this) and impressively were able to properly take the holdings of managers and come up with a proper risk picture (if you believe that rating agency ratings of bonds reflects the true risk but that for another post). Morningstar basically said that they have a crappy dataset which just doesn't have rating data for many bonds and therefor, when they don't have a value, they just fill in with a default. This makes me think that Morningstar is doing a pretty lazy job in their evaluation of managers (what incentive do they really have, they are a monopoly in this area). Happy to answer any questions people have.
- smallnamespace 7y agoHow do managers construct bond portfolios nowadays? Are they just picking some parameters (e.g. domestic, muni, etc.) or a benchmark and then letting software do the actual security selection?
- trailrunner46 7y agoMost of the AUM are in portfolios that are benchmarked to something (Barclays/Bloomberg US Aggregate for example). Although recently there has been a surge in unconstrained bond funds which have more latitude in terms of what they hold and with a looser benchmark. Managers start with a benchmark and then make 2 main choices. 1) how much should I deviate in terms of asset type exposure (benchmark is 40% IG corporate, should I do 50% and overweight?) and 2) within each asset type exposure which securities should I select (within my IG corporate sleeve should I choose the newly issues IBM bonds, old issue IBM bonds, Apple?, etc). Most managers are still pretty manual so the are doing deep securit research and are picking company A over company B but there is some movement to a more quant approach where you pick metrics and do a broad screen across all of those companies. The data across all of the bonds especially outside of just investment grade is hard to get access/clean so that has been a barrier to entry for a while. As the data becomes more available more managers will be using screens like has been commonly been done in equities.
- JackFr 7y agoThe Morningstar fixed income style box considers risk along two axes, credit and interest rates. I'm curious if the authors considered misreporting of interest rate risk. It's interesting because the duration of the portfolio (the measure of exposure to interest rates) is not subject to the whims of ratings bureaus, and it is a straightforward calculation -- and yet Morningstar relies on a survey of the manager to get the portfolio duration.
- MR4D 7y agoIf the PM lies about this to Morningstar, they are in violation of the law. Specifically, I believe that they would fall afoul of FINRA Rule 2210 [0] and SEC Rule 34b-1 [1]. (I run a financial firm, but am not a lawyer, so they may target different rules specifically for the issue of bond duration.) [0] - https://www.finra.org/rules-guidance/rulebooks/finra-rules/2210 https://www.finra.org/rules-guidance/rulebooks/finra-rules/2... [1] - https://www.law.cornell.edu/cfr/text/17/270.34b-1 https://www.law.cornell.edu/cfr/text/17/270.34b-1