A new academic paper shows mutual fund names often do not reflect their actual investment style and argues the phenomenon is sufficiently widespread, and unrecognized by investors, that the Securities and Exchange Commission should enforce stricter name regulation.
The study by a group of European academics states that 33% of U.S. equity mutual funds have had an inaccurate name at least once during their life-cycle.
“We find that funds that provide an inaccurate name experience lower fund inflows, are relatively older, and charge higher expense ratios,” the authors note. The study also observed increased idiosyncratic risk and a reduction in fund outperformance after a fund features an inaccurate name.
Moreover, after an inaccurate name change goes into effect, investors “do not sufficiently react” by investing less in these funds, the authors write.
Anne-Florence Allard at the Research Foundation - Flanders (FWO), Belgium; Jonathan Krakow of the University of Zurich, Switzerland; and Kristien Smedts of KU Leuven, Belgium, published their findings last month in a 31-page paper titled “When Mutual Fund Names Misinform.”
The authors examined a sample of 2,152 U.S. equity open-ended mutual funds linked to 2,743 different names between 2010 and 2018. “The key to our analysis is the strict control of fund names by creating a detailed fund name history based on more than 400,000 mutual fund prospectuses,” the report states.
The authors argue that past performance offers clues as to when in a fund’s life-cycle it is more prone to have its name changed. Funds often become inaccurate “when they performed relatively well in the year before but rather badly in the quarter before.”
In explaining why inaccurately named funds don’t match the composition of their portfolios, the study examines two possibilities. In the first scenario, funds neglect to update their portfolios. In this instance, style drift could be a natural byproduct of a manager failing to ensure the portfolio reflects the fund’s stated objective. This would constitute a passive oversight. The second scenario involves the active reallocation of assets in a way that doesn’t adhere to the fund’s mission. The study’s results “provide evidence for the latter.”
In July 2001, the SEC introduced Rule 35d-1, also referred to as the Names Rule, which requires funds to invest at least 80% of their portfolio in the asset class, sector or geographic region mentioned in the fund name. The rule does not, however, enforce the stated asset size of a fund’s holdings, be it small or large companies based on market capitalization, or investment strategies, such as growth or value.
In March, the SEC sought public comments regarding the effectiveness of Rule 35d-1. “Strongly motivated by this ongoing concern from regulators,” the study’s authors focused their analysis on company size and investment strategy.
“Our results, therefore, show that investors may experience difficulties in noticing inaccurate fund name information, for sure in a timely fashion. This calls for the need for a stricter name regulation,” the report states.