Once again, the financial industry has shown it’s true colors, and it’s not pretty. This time it comes in the form of mutual fund benchmarks.
A new study looked at the underhanded tendency of active mutual fund managers to “move the goal posts” and manipulate the attractiveness of their historical performance figures. If you thought that mutual funds had to be ethical, upfront, and transparent about historical performance data, you would have been wrong.
Under existing SEC rules, a mutual fund can freely change it’s performance benchmark at any point. A mutual fund can even backdate the benchmark choice. And by doing so, it’s very possible that the fund’s historical performance will look better.
To wit:
Funds exploit this loophole by adding (dropping) indexes with lower (higher) past returns, which materially improves the appearance of their benchmark-adjusted performance.
-Kevin Mullally and Andrea Rossi (Moving the Goalpost? June 24, 2022)
What does this mean?
Let’s start by explaining what a benchmark does. It’s really just a way to keep score when it comes to mutual fund performance. If the fund performs better than the benchmark, that’s good. If not, that’s bad.1
The SEC only requires that mutual funds use an “appropriate” benchmark. Sound vague? It sure is! And the SEC is comfortable letting mutual fund companies decide exactly what “appropriate” means. Obviously, this leaves a huge opportunity for mutual fund companies to game the system.
The authors of the study analyzed 2,870 funds over a 13-year period (2006 to 2018). They found that 36.5% of funds made changes to their benchmarks at least once during the period. Looking only at that 36.5% subset of funds, the median number of benchmark changes was 2.27. When these funds change their benchmark, they do so about every 6 years.
Why bother changing the benchmark?
The authors of the study point out that, for better or worse, it’s common practice for many investors and their financial advisors to select potential investment funds based on historical performance relative to the benchmark. Even though historical performance offers very little insight into future performance, many people find comfort in an investment fund that his been able to outperform it’s benchmark.
How do mutual funds take advantage of this tendency? They simply choose a benchmark with worse performance. The authors found that funds chose new benchmarks with 5-year returns that were 2.4% lower than the previous benchmark. Think about that for a moment. The funds performance didn’t change one bit, but merely changing the benchmark provides a 2.4% relative boost to the funds returns in the eyes of investors.
What’s the “best” benchmark?
Is it difficult for a mutual fund to pick a “best” index to use as a benchmark? No!
The financial industry uses a handy statistical measure called r-squared (R2) to determine how well a index matches a given mutual fund. If the returns of the benchmark index are closely aligned with the fund’s returns, then they have a high R2. If not, then R2 is low.
The financial industry also uses a metric called “tracking error”, which measures the size of the difference between the returns of the mutual fund and the benchmark. For our purposes, high tracking error is bad, low tracking error is good.
If you choose the index with the highest R2 and the lowest tracking error, then you have found the “best” benchmark (or at least got pretty darn close).
When the authors analyzed the data using this idealized “best” benchmark standard, they found that 5-year fund returns looked not 2.4% better, but a whopping 5.6% better. The difference in 10-year returns was even worse… 9.4%. The authors found that the probability of these changes being random was practically zero.
Long story short, many mutual fund investors are being misled to the tune of over 5% (or more)!
Steps to fix
In a perfect (or at least rational) world, the SEC would mandate that a mutual fund must use the index that has the highest R2 and lowest tracking error as the benchmark. This one change would almost guarantee that a mutual fund is using a high-quality benchmark.
Another thing the SEC could do is prohibit funds from backdating their benchmark choices. The standard really should be “you chose it, you own it”. If a mutual fund uses one index for 5 years, but wants to make a change, that’s ok. But the fund managers shouldn’t be able to use the new benchmark for the 5 year historical performance, only for future performance. In essence, the fund could change benchmarks, but only on a forward looking basis.
And finally, the SEC should mandate that mutual funds can only use one benchmark. Some funds use more than one, and it’s ridiculous. One benchmark, especially a high-quality one, is plenty.
This study provides a good reminder that the financial industry has plenty of work to do when it comes to ethical behavior. These mutual funds are misleading investors and it’s discouraging. As with many things in life, this dubious behavior is driven by money. The authors of the study found that the mutual funds most likely to change their benchmark were experiencing significant outflows due to poor performance, or were broker-sold and hence wanted to use better historical performance as a selling point when pitching the fund to clients.
The lesson here is to avoid active mutual funds whenever possible. Many of them can’t be trusted. In addition to bad performance data, active mutual funds also have high fees, and often cause significant tax headaches. Better to stick with a passive investment approach. If you do choose to use active funds, be sure to do your research.
1 It can get more complicated than that. There is a concept called “risk adjusted performance” which attempts to measure how a fund performs when adjusted for volatility, or the “bumpiness” of the returns over time.
