One of the most important, but also unsung, benefits of using index funds is that you know exactly what you're investing in. They're simple, transparent investments, without any nasty surprises.

Index funds are also style-pure. If, for example, you buy a U.S. small-cap fund, it will only contain U.S. small-cap stocks. Actively managed funds, on the other hand, often include multiple types of stocks, and even different asset classes. Just like convenience food, the ingredients can change without you even realizing.

Over the years, financial academics have identified all sorts of methods employed by fund management companies to give the impression that their funds have performed better than they actually have. One way they do it is through what we call style drift, or deviating from the fund's stated style or investment strategy.

Craig Lazzara, retired Managing Director at S&P Dow Jones Indices, has written several times about "performance trickery" related to style drift. In a 2021 report, Style Bias and Active Performance, Lazzara and his colleagues wrote: "Whenever there are significant differences between the performance of capitalization-specific indices, there are opportunities for managers to add value by moving up or down the cap scale. Such opportunistic moves may be commendable, but they are not evidence of skill at stock selection."

"Box Jumping"

A recent study highlights a new example of style-related performance trickery, which the authors refer to as box jumping. The paper is called Box Jumping: Portfolio Recompositions to Achieve Higher Morningstar Ratings, and it's authored by Lauren Cohen from Harvard Business School and David Kim and Eric So from MIT's Sloan School of Management.

Cohen, Kim and So set out to examine the effects of Morningstar ratings on fund flows, fees and performance. They specifically focused on the introduction, in 2002, of Morningstar's current system of dividing funds between nine different style boxes.

We know from a 2022 study, What Do Mutual Fund Investors Really Care About?, by Ben-David, Rossi and Song, that star ratings from Morningstar are the most significant driver of mutual fund flows. Investors rely heavily on these ratings when making allocation decisions, often fixating on the ratings themselves without fully understanding how they are derived or considering the underlying performance or risk characteristics of the funds. This reliance creates strong incentives for fund managers to manipulate their portfolios to achieve higher ratings.

Since 2002, Morningstar has grouped funds based on the size and value profiles of the securities they hold. It regularly reassigns funds in response to changes in their holdings. When a fund moves, or "jumps", from one style box to another, Morningstar immediately starts comparing the fund's historical performance against other funds in its newly assigned box.

Deliberate Manipulation

What the researchers found was that funds deliberately change their holdings so that Morningstar has to reclassify them in a style box with lower average performance. Hey presto, compared to their peers, the performance of those funds suddenly looks much better. As a result, they move from, say, a two- or three-star rating to a four- or five-star rating, instantly making themselves more attractive to investors.

So how do we know that funds are doing this on purpose, to game the ratings system? We can't be certain, and, for obvious reasons, fund providers are unlikely to admit it. But Cohen, Kim and So believe the evidence points to deliberate manipulation.

"Importantly," they write, "funds are more than twice as likely to receive a rating upgrade than a downgrade as a result of moving to a new style box… (which) casts significant doubt on the notion that box jumping occurs randomly. Additionally, this strong asymmetry toward receiving an upgrade only emerges after Morningstar changed its rating system in 2002 and is predictably absent beforehand."

The researchers also found that box jumping was a very common practice. It occurred 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.

Big Benefits for Funds

Another important finding from the study is that funds that received rating upgrades achieved through box jumping benefited hugely. On average they saw a rise in assets under management of 6.7% over the next 12 months.

What's more, many of these same funds took their rating upgrade as an opportunity to increase the management fees they charged. "Using a simple back-of-the-envelope calculation," the authors say, "we estimate that funds receive an additional $1.05 million in fee revenues per year on average for each rating upgrade received when box jumping, representing about a 12% increase in their annual fee."

To add insult to injury for investors in these funds, Cohen, Kim and So also found that box jumping usually resulted in worse performance. To quote from the paper: "Five-star funds that receive their upgrades through box jumping underperform five-star upgraded funds which do not by roughly eight percentage points over the following five years.

"We also show that ratings upgrades driven by box jumping are transitory. While funds receive an immediate ratings upgrade upon box jumping, the upgrade is completely reversed within three years."

"Sad but Not Surprising"

Commenting on the paper, Ludovic Phalippou, Professor of Financial Economics at the University of Oxford, said he found it "funny, sad, enraging and not surprising at the same time."

Professor Phalippou went on: "Imagine if all these people in the finance industry who spend their energy and talent doing these things did something useful for society instead!"

For investors, it's another reminder that fund management companies will stop at almost nothing to persuade you to pay to invest in their funds. Be very skeptical, then, about self-reported performance, and never rely on star ratings. You're almost certainly better off avoiding style drift altogether, and investing in a diversified portfolio of index funds instead.

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ROBIN POWELL is IFA's Creative Director. He always works as a freelance journalist and author, and as Editor of The Evidence-Based Investor.

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*Quotes and pictures are utilized for illustrative purposes only and should not be construed as an endorsement, recommendation, or guarantee of any particular financial product, service, or advisor.

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