Could SEC loophole let fund firms exaggerate their performance?

Regulator's transparency rules could unintentionally allow deceptive practices, researchers say

Could SEC loophole let fund firms exaggerate their performance?

Mutual fund investors who evaluate their returns in relation to benchmark indexes might be astonished to learn that funds might alter their benchmark to exaggerate performance.

A recent study, "Moving the Goalposts? Mutual Fund Benchmark Changes and Performance Manipulation," revealed that some mutual funds exploit a weakness in U.S. criteria for disclosure set forth by the Securities and Exchange Commission not "to disclose false information regarding prior performance."

As reported by ThinkAdvisor, 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.” 

The researchers stated, citing prior studies, that mutual fund investors base their capital allocation choices on funds' historical performance, using quite easy and accessible indicators.

They also used data from a 2016 Federal Reserve poll showing that, while just 13% of American households engaged directly in the stock market, more than half did so through intermediate vehicles like mutual funds.

Mutual funds are required by SEC Rule 33-6988 to report at least one suitable broad-based market index with which they benchmark their historical performance, as well as comparisons of their 1-, 5-, and 10-year returns to those of the benchmark index.

According to the researchers, the SEC's mandate is based on the necessity for investors to assess the value management brought by determining whether the fund outperformed or underperformed the market.

By reviewing prospectuses that were retrieved from the SEC website, the researchers looked at benchmark changes made by funds.

They discovered:

  • In the 13-year sample period from 2006 to 2018, 1,050 out of 2,870 funds, or 36.5%, changed their prospectus benchmarks at least once.
  • The median number of adjustments made by funds with at least one benchmark change was two.
  • Of all fund-year data, benchmark modifications happened in 6.85% of the cases.

Although funds may switch benchmarks for a variety of reasons, the researchers discovered that benchmark changes result in a systematic decline in the prior benchmark returns that funds report.

The data revealed that funds add indices with 2.39% lower 5-year returns than their current benchmarks and 5.56% lower 5-year returns than the index that best matches their strategy, findings that the researchers deemed to be highly statistically significant.