About a third of US fixed income funds are more risky than their Morningstar ratings suggest, according to a new study.
The research by a trio of US academics found the highly-influential Morningstar ratings systematically ‘misclassified’ bond funds due to an over-reliance on manager-supplied data.
Roughly 30 per cent of US bond funds fed data to Morningstar that under-reported the actual proportion of riskier assets in their portfolios, the study says.
US fixed income fund “misreporting has been not only persistent and widespread, but also appears to be strategic”, the ‘Don’t take their word for it: The Misclassification of Bond Mutual Funds’ paper says.
“In particular, we show that investors’ reliance on Morningstar has resulted in significant investment based on verifiably incorrect reports by fund managers that Morningstar simply passes on as truth,” the report says.
The researchers compared the reported Morningstar bond risk profiles against actual portfolio holdings registered with the Securities Exchange Commission (SEC) – the US financial regulator.
But while the SEC data was also available to Morningstar, the research house uses the manager self-reported data to underpin its product classification and star-ratings, according to the study.
“Thus, it is literally that Morningstar uses the Summary Reports itself (and not the other data also delivered directly to it by funds) instead of taking the extra step of calculating riskiness itself that contributes to classification,” the paper says.
However, in a statement Morningstar refuted the academics’ claims, arguing there were “other explanations for the differences” between the self-reported and actual bond fund risk levels.
The global investment research house attributed the mis-match to its process that classified some underlying securities as “not rated”.
“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,” the statement said. “The authors say a ‘misclassification’ of funds allows them to receive higher star ratings than they should have. This is not true.”
Morningstar had since contacted the authors of the study: professors Huaizhi Chen, Lauren Cohen and Umit Gurun of the University of Notre Dame, Harvard Business School and the University of Texas, respectively.
The paper says the findings suggest further research “should explore alternate monitoring and verification mechanisms for increasingly complex information aggregation in financial markets, and ways that investors can engage as important partners in information collection and price-setting in modern capital markets”.
Meanwhile, Morningstar Australia has moved from observer to participant in the burgeoning exchange-traded fund (ETF) with the launch of a new ASX-listed global equities product last week.
The Morningstar International Shares Active ETF feeds into an unlisted actively-managed fund that focuses on “fundamental, valuation-driven” factors, the researcher says.
While primarily a purveyor of investment research and associated paraphernalia, Morningstar has a substantial product line, especially in the US. According to the firm’s September quarter report, Morningstar has almost US$150 billion in assets under management in its ‘workplace solutions’ products and a further US$46 billion or so in ‘managed portfolios’.
The global business manages almost US$70 billion of investment assets, including US$16 billion of institutional money.
In Australia, Morningstar offers ‘managed account’ portfolios – a major growth area across the Tasman – among other investment services.
The Australian arm, too, has been on an acquisition trail of late, snapping up the industry publication Cuffelinks (for about A$300,000) and last month and announcing plans to buy financial planning software business, AdviserLogic, earlier in November.