
Don’t Take Their Word for It: The Misclassification of Bond Mutual Funds - luu
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3474557
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trailrunner46
As 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.

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ethbro
What legal agreements actually exist between ratings agencies and their
consumers?

As I understand it, there are legal agreements that take ratings as an input
(e.g. a pension may only invest in investment grade bonds).

But is there actually any way for a consumer to sue Morningstar? Or are their
ratings essentially just "proprietary numbers", no warranty given?

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lotsofpulp
Based on the consequences to the ratings agencies of fraudulently (or
erroneously) rating mortgage debt in 2000s, there are no laws requiring
ratings agencies to be accountable to anyone.

The sellers of the debt, or financial products, are the ones that pay the
ratings agencies, so they are the real customers.

The buyers should be doing due diligence, especially considering the conflict
of interest, but they are also frequently agents on behalf of taxpayers (for
government pensions) or other far removed investor, so agency risk is big here
too.

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Alekanekelo
Morningstar published a response to this paper [0].

[0] [https://www.morningstar.com/learn/bond-ratings-
integrity](https://www.morningstar.com/learn/bond-ratings-integrity)

~~~
frgtpsswrdlame
Hmm, 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.

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JackFr
The 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
If 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/2...](https://www.finra.org/rules-guidance/rulebooks/finra-rules/2210)
[1] -
[https://www.law.cornell.edu/cfr/text/17/270.34b-1](https://www.law.cornell.edu/cfr/text/17/270.34b-1)

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XnoiVeX
Many 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.

~~~
alexhutcheson
> 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.

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clevergadget
This is the article I wanted informed comments on the most

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metalliqaz
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.

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Maarten88
> slimy and dishonest

Wouldn't this rise to the level of fraudulent and thus criminal?

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corey_moncure
It'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.

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jacquesm
You _really_ should add that /s.

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jjoonathan
Why?

