Page 41 - Investment Advisor October 2022

PORTFOLIO PERSPECTIVES

By Dinah Wisenberg Brin

SEC Loophole Lets Funds Mislead Investors

on Performance: Study

Some funds change their benchmark indexes to “manipulate the benchmark-

adjusted performance they present to investors,” researchers found.

nvestors exploring mutual funds
and comparing their returns to
Ibenchmark indexes may be sur-
prised to know that funds can change
their benchmark to make performance
appear better than it is. A new study,
“Moving the Goalposts? Mutual Fund
Benchmark Changes and Performance
Manipulation,” found that some mutu-
al funds take advantage of a loop-
hole in U.S. Securities and Exchange
Commission disclosure requirements
“to provide misleading information
about past performance.”
SEC rules allow funds to “freely
change their benchmark indexes and,
implicitly, the historical returns to which only 13% of U.S. households invested were generated,” they wrote.
they compare their past performance,” directly in the stock market, more than “In essence, these rules allow funds
wrote Kevin Mullally of the University half invested in intermediary vehicles to manipulate the benchmark-adjusted
of Central Florida and Andrea Rossi like mutual funds. performance they present to investors
of the University of Arizona finance SEC Rule 33-6988 requires mutual simply by changing their benchmark
department. “Funds exploit this loop- funds to disclose at least one appropri- index,” they added.
hole” by adding indexes with lower past ate broad-based market index to which The researchers studied funds’ bench-
returns or dropping indexes with higher they compare their past performance, mark moves by examining prospectuses
returns, “which materially improves the providing comparisons of their 1-, 5-, downloaded from the SEC website.
appearance of their benchmark-adjust- and 10-year returns to those of at least They found that:
ed performance,” they said. one benchmark index. • 1,050 out of 2,870 funds, or 36.5%,
“High-fee funds, broker-sold funds The SEC bases the requirement on made changes to their prospectus
and funds experiencing poor perfor- investors’ need to evaluate how much benchmarks at least once over the
mance and outflows are more likely to value management added by show- 13-year sample period spanning
engage in this behavior,” the research- ing whether the fund outperformed 2006 to 2018.
ers wrote. “These funds subsequently or underperformed the market, the • Among funds making at least one
attract additional flows despite continu- researchers noted. benchmark change, the median
ing to underperform their peers.” “Given this rationale, it is perhaps sur- number of changes was two per fund.
Mutual fund investors base their prising that the rule allows funds to add • Benchmark changes occurred in
capital allocation decisions on funds’ and remove benchmark indexes with 6.85% of all fund-year observations.
past performance, using relatively little justification and does not prohibit While funds may change benchmarks
simple and readily available measures, funds from comparing their past returns for many reasons, the researchers found
Adobe Stock studies. They also cited a 2016 Federal er than to the returns of the index(es) tematic decrease in the past benchmark
to those of newly-chosen index(es) rath-
that benchmark changes lead to a sys-
the researchers noted, citing previous
returns that funds report.
Reserve survey indicating that while
they selected at the time the returns
OCTOBER 2022 INVESTMENT ADVISOR 39