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This episode aired on Bloomberg TV on May 6, 2013

Prospectus Benchmark

Q. So this is the benchmark that a mutual fund chooses to measure itself against… what’s so interesting about that?

A. Yes, at one level its sort of boring. At formation, mutual funds choose which standard benchmark they’ll use: the S&P, the MSCI World, whatever. Where it gets interesting, though, is that these benchmarks can wind up being very misleadiing to investors, because the fund is not really investing in the same mix that the benchmark represents. And its a big issue now with bond funds.

Q. Really, how so? Surely a bond fund measures itself against a bond index…

A. That’s exactly where the problem is. Moringstar just issued a report that says over 300 “bond” funds are now meaningfully invested in…. stocks! That’s the highest number on record. And those juicy dividends are why these funds appear to be outperforming the pure bond indexes against which they measure themselves.

Q. So this is another example of the search for yield in a zero interest rate environment…

A. Definitely. The bond managers are saying, gee, I don’t know if I’m being compensated for the interest rate risk in these assets (and they’re not!). So I need to find another way to get income, and many are buying dividend stocks as a result. That throws off the comparison to the Prospectus Benchmark, but it also fouls up RIA diversification models…. its a form of “style drift” that we’ve talked about before.

Q. But are these meaningful investments in stocks, or just a tiny allocation to get the returns up a touch?

A. Depends… some “income” funds are allowed by their prospectus to go up to 35% in dividend stocks, and they are. But even “bond” funds can usually invest up to 20% in other things… and some very well known ones are bumping right up against that limit.

Q. And I guess you’re going to tell me there’s really nothing impermissible about that..

A. Correct, that’s the way the rules are written, and all this is disclosed, its not a secret. But next time you see a bond fund meaningfully outperforming its Benchmark Index, take a look under the covers.