What Does a Mutual Fund’s Term Tell Investors?

Abstract

In a previous article, we highlighted a flaw in the average credit quality statistic frequently reported by bond mutual funds. That statistic understates the credit risk in bond portfolios if the portfolios contain bonds of disperse credit ratings. We explained that portfolio managers wanting to increase their yields could adjust their holdings to increase the credit risk investors were exposed to without increasing the risk signaled by the average credit quality statistic.

In this article we address a similar problem with bond mutual funds’ reporting of the average term of their portfolios. The somewhat ambiguous nature of this statistic provides an opportunity for portfolio managers to significantly increase the funds’ risks, credit risk in particular, by holding very long-term bonds while claiming to expose investors to only the risks of very short-term bonds.

TOPICS: Statistical methods, portfolio construction, credit risk management