Not getting the right returns relative to a given benchmark? Simply change the benchmark.
“Funds exploit this loophole by adding (dropping) indexes with lower (higher) past returns, which materially improves the appearance of their benchmark-adjusted performance.”
Ethically questionable tricks to boost mutual fund performance—for instance, citing a particular track record without noting survivorship bias—have long plagued participants. Legally questionable tricks like backdating and late trading resulted in actual charges for major investment firms in the early 2000s.
And now, a new research paper illustrates how simply changing the criteria against which a fund is measured is deceiving investors and hiding disappointing performance.
In “Moving the Goalposts? Mutual Fund Benchmark Changes and Performance Manipulation,” Kevin Mullally of the University of Central Florida and Andrea Rossi of the University of Arizona used prospectus to analyze changes that mutual funds made to their benchmarks.
They noted that under existing SEC rules, funds can change their benchmark indexes “and, implicitly, the historical returns to which they compare their past performance.”
“Funds exploit this loophole by adding (dropping) indexes with lower (higher) past returns, which materially improves the appearance of their benchmark-adjusted performance,” the authors wrote. “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.”
Even worse, they claimed they found evidence that funds provided misleading information to investors in their SEC-mandated disclosures.
“[Although] the behavior we document does not appear to be technically illegal, 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,” they concluded. “The SEC has proposed simplifying funds’ disclosures to investors. Our study suggests that new disclosure guidelines, which would make these relative performance comparisons more salient to investors, may adversely affect unsophisticated investors if enacted without additional requirements for how funds report their past performance information.”