SEC Loophole Lets Funds Mislead Investors on Performance: Study

What You Need to Know

SEC rules allow funds to change their benchmark indexes, and about a third of funds in a study did so.
Some funds change indexes for legitimate reasons, but poor performers are more likely to switch and inflows rise after they do so, researchers found.
The behavior appears to be legal but seems to conflict with the SEC’s transparency goals, researchers said.

Investors exploring mutual funds and comparing their returns to benchmark indexes may be surprised 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 mutual funds take advantage of a loophole 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 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.” 

Mutual fund investors base their capital allocation decisions on funds’ past performance, using relatively simple and readily available measures, the researchers noted, citing previous studies. They also cited a 2016 Federal Reserve survey indicating that while only 13% of U.S. households invested directly in the stock market, more than half invested in intermediary vehicles like mutual funds.

SEC Rule 33-6988 requires mutual funds to disclose at least one appropriate broad-based market index to which they compare their past performance, providing comparisons of their 1-, 5-, and 10-year returns to those of at least one benchmark index. 

The SEC bases the requirement on investors’ need to evaluate how much value management added by showing whether the fund outperformed or underperformed the market, the researchers noted. 

“Given this rationale, it is perhaps surprising that the rule allows funds to add and remove benchmark indexes with little justification and does not prohibit funds from comparing their past returns to those of newly-chosen index(es) rather than to the returns of the index(es) they selected at the time the returns were generated,” they wrote.

“In essence, these rules allow funds to manipulate the benchmark-adjusted performance they present to investors simply by changing their benchmark index,” they added.

They researchers studied funds’ benchmark moves by examining prospectuses downloaded from the SEC website.

They found that:

1,050 out of 2,870 funds, or 36.5%, made changes to their prospectus benchmarks at least once over the 13-year sample period spanning 2006 to 2018.
Among funds making at least one benchmark change, the median number of changes was two per fund. 
Benchmark changes occurred in 6.85% of all fund-year observations. 

While funds may change benchmarks for many reasons, the researchers found that benchmark changes lead to a systematic decrease in the past benchmark returns that funds report.

“On average, funds add indexes with low past returns and drop indexes with high past returns. Similarly, many funds also add peer-based benchmarks (reflecting other funds’ average return) with low returns and drop peer-based benchmarks with low returns,” they said.

“Added stock-based and peer-based benchmarks have lower returns than those of the benchmarks that better match funds’ actual investment strategy. Finally, added benchmarks tend to have low returns both because funds choose to add benchmarks with low past style returns and because funds pick low-return benchmarks within a given style,” they said.

The data showed that funds add indexes with 2.39% lower 5-year returns than their existing benchmarks and 5.56% lower 5-year returns than the index that best matches their strategy, results that the researchers found to be highly statistically significant.” The probability of observing these results by chance is extremely low, they added.