“Unmasking the Deception: How Fund Companies Manipulate Ratings to Their Advantage”

One of the most significant, yet often overlooked, advantages of utilizing index funds is the clarity regarding your investments. They are straightforward, transparent assets, devoid of any unpleasant surprises.

Moreover, index funds adhere strictly to their defined style. For instance, purchasing a U.S. small-cap fund means it will solely include U.S. small-cap equities. In contrast, actively managed funds frequently comprise diverse categories of stocks, and even various asset classes. Similar to pre-packaged meals, the components can change without your awareness.

Over time, financial scholars have uncovered numerous tactics used by fund management firms to create the illusion that their funds have outperformed reality. One method includes what we term style drift, which involves straying from the fund’s declared style or investment approach.

Craig Lazzara, a retired Managing Director at S&P Dow Jones Indices, has frequently discussed “performance deception” concerning style drift. In a 2021 analysis, Style Bias and Active Performance, Lazzara and his associates remarked: “Whenever notable differences arise between the performance of capitalization-specific indices, there are avenues for managers to enhance value by shifting up or down the capitalization scale. Such opportunistic transitions may be admirable, yet they do not demonstrate adeptness in stock selection.”

“Box Jumping”

A recent research highlights a new instance of style-related performance deception, which the authors denote as box jumping. The paper, titled Box Jumping: Portfolio Recompositions to Achieve Higher Morningstar Ratings, is authored by Lauren Cohen from Harvard Business School alongside David Kim and Eric So from MIT’s Sloan School of Management.

Cohen, Kim, and So aimed to assess the impact of Morningstar ratings on fund inflows, fees, and performance. They specifically examined the establishment, in 2002, of Morningstar’s current classification system dividing funds into nine distinct style boxes.

A 2022 study entitled What Do Mutual Fund Investors Really Care About?, conducted by Ben-David, Rossi, and Song, indicated that Morningstar’s star ratings are the foremost influence on mutual fund inflows. Investors heavily depend on these ratings while making allocation decisions, often focusing on the ratings themselves without fully grasping the basis of their derivation or contemplating the underlying performance or risk attributes of the funds. This dependence generates substantial incentives for fund managers to manipulate their portfolios to attain higher ratings.

Since 2002, Morningstar has categorized funds based on the size and value characteristics of the securities they encompass. It routinely reassigns funds based on modifications in their holdings. When a fund shifts, or “jumps”, from one style box to another, Morningstar promptly begins evaluating the fund’s historical performance in relation to other funds in its newly assigned category.

Intentional Manipulation

The researchers discovered that funds intentionally adjust their holdings so that Morningstar must reclassify them into a style box with lower average performance. Abracadabra, compared to their peers, the performance of those funds suddenly appears significantly improved. Consequently, they transition from a two- or three-star rating to a four- or five-star rating, making themselves instantly more appealing to investors.

So how can we ascertain that funds are doing this intentionally to exploit the ratings system? While we cannot be entirely sure, and for apparent reasons, fund providers are unlikely to confess. However, Cohen, Kim, and So contend that the evidence suggests intentional manipulation.

“Importantly,” they assert, “funds are over twice as likely to receive a rating upgrade than a downgrade as a consequence of transferring to a new style box… (which) casts substantial doubt on the idea that box jumping takes place randomly. Additionally, this pronounced asymmetry towards receiving an upgrade only becomes evident after Morningstar adjusted its rating system in 2002, and is conspicuously absent prior to that.”

The researchers also unearthed that box jumping is a prevalent practice. It happened in approximately 9% of the funds in their sample each year, with 24% of funds and 37% of fund managers having experienced at least one box jump between 1997 and 2007.

Significant Advantages for Funds

Another pivotal discovery from the study is that funds receiving rating upgrades via box jumping experienced considerable benefits. On average, they observed a surge in assets under management of 6.7% over the following 12 months.

Furthermore, many of these same funds utilized their rating upgrade as an opportunity to raise the management fees they imposed. “Using a straightforward back-of-the-envelope calculation,” the authors explain, “we estimate that funds obtain an extra $1.05 million in fee revenues annually for each rating upgrade received due to box jumping, representing about a 12% increase in their yearly fee.”

To make matters worse for investors in these funds, Cohen, Kim, and So also found that box jumping typically resulted in poorer performance. To quote from the paper: “Five-star funds that attain their upgrades through box jumping underperform five-star upgraded funds which do not by approximately eight percentage points over the subsequent five years.”

“We also demonstrate that ratings upgrades driven by box jumping are temporary. While funds receive an instant ratings upgrade upon box jumping, the upgrade is entirely reversed within three years.”

“Disheartening but Not Unexpected”

In comments regarding the paper, Ludovic Phalippou, Professor of Financial Economics at the University of Oxford, expressed that he found it “comical, disheartening, infuriating, and simultaneously not surprising.”

Professor Phalippou continued: “Consider if all the individuals in the finance sector who dedicate their energy and talents toward these activities channeled it towards something beneficial for society!”

For investors, this serves as another reminder that fund management firms will go to great lengths to convince you to pay for investing in their funds. Therefore, it’s wise to remain skeptical regarding self-reported performance and never base your decisions solely on star ratings. You would almost certainly be better off steering clear of style drift altogether and instead investing in a well-diversified portfolio of index funds.

ROBIN POWELL is IFA’s Creative Director. He consistently operates as a freelance journalist and author, as well as the Editor of The Evidence-Based Investor.

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