1) Office of the Investor Advocate Releases Research Study on Fund Performance Benchmarks (news release)
Researchers from the SEC’s Office of the Investor Advocate (OIAD) released an independent research study examining the impact of mutual fund performance benchmarks on investor decision-making, and potential strategic behavior by firms in displaying benchmarks. This study examines market data and the results of a large behavioral experiment to understand how funds employ benchmarks and how investors respond to benchmark presentation.
The research study was published on the OIAD website and has been placed in the comment file (No. S7-09-20) for a rulemaking package that would, among other things, modernize open-end fund shareholder reports. The proposal, which was proposed by the Commission in August 2020, features concise and visually engaging shareholder reports that would highlight information that is particularly important for retail investors to assess and monitor their fund investments.
Analysis in the research study may be informative for evaluating comments on the proposed requirements for funds’ performance disclosure. The authors are making this analysis available to allow the public to consider this supplemental information. Comments on this supplemental information may be submitted to the comment file (File No. S7-09-20) for the proposal.
2) How do Consumers Understand Investment Quality? The Role of Performance Benchmarks (study)
We study the impact of mutual fund performance benchmarks on investor decisionmaking and potential for strategic behavior by firms in displaying benchmarks. In displaying performance, fund companies are required to present a broad-based securities market index (“broad benchmark”), and an optional secondary (“narrow”) benchmark that, in some instances, can be more representative of the fund’s sector or strategy. Importantly, fund companies have discretion over the choice of benchmarks, within the confines that the benchmarks they select must meet the criteria that the federal securities laws require, presenting opportunity for strategic selection. Our research examines market data and the results of a large behavioral experiment to understand how fund companies employ benchmarks and how investors respond to the presentation of benchmarks.
Standard economic theory does not provide a straightforward role for how benchmarks affect investor decisions. In the experiment, we examine two primary outcomes: (1) subjective attractiveness ratings for a synthetic fund and (2) an incentive-compatible participation outcome that offers participants the choice between our fund and a guaranteed return over a six-month holding period. We administer treatment conditions that vary the number of benchmarks presented, the relative position of the benchmark vis-à-vis our synthetic fund, the use of broad or narrow benchmarks, and the use of narrative text. Our results indicate that investors respond to benchmarks. In particular, subjective attractiveness ratings are much lower when participants view fund performance accompanied by a single benchmark that outperforms the fund. This decrease in attractiveness also occurs, to a lesser extent, when participants view two benchmarks that both outperform and underperform the fund. Allocations to the synthetic fund are also lower when participants see a single benchmark above the fund. Surprisingly, participants with higher investment sophistication appear to react most strongly to benchmarks (rather than lower sophistication individuals). Additionally, the distinction between narrow and broad benchmarks and the narrative descriptive text about the benchmarks do not have a differential impact beyond the position of the benchmark. Finally, using an economic model, we ask what type of benchmark presentation gets investors closest to their optimal allocation, finding that conditions with no benchmark and with two benchmarks minimize distortions.
Using data from the Morningstar Direct database, we contextualize these findings and the concerns that our results raise in situations where funds have discretion regarding the selection of benchmarks. Specifically, we document performance variation of benchmarks within a given sector, as well as the decision to present a secondary benchmark. Ultimately, these patterns raise the possibility that funds can pick benchmarks that satisfy the requirements for permissible benchmarks, but are relatively poor performing as compared to other permissible benchmarks. This would put the fund’s relative performance in a more positive light, which may affect investors’ evaluations and investment decisions.