“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.”
The researchers stated, citing prior studies, that mutual fund investors base their capital allocation choices on funds’ historical performance, using quite easy and accessible indicators.
They also used data from a 2016 Federal Reserve poll showing that, while just 13% of American households engaged directly in the stock market, more than half did so through intermediate vehicles like mutual funds.
Mutual funds are required by SEC Rule 33-6988 to report at least one suitable broad-based market index with which they benchmark their historical performance, as well as comparisons of their 1-, 5-, and 10-year returns to those of the benchmark index.
