Misspecified benchmarks are widespread among active bond mutual funds, driven in part by the industry’s heavy dependence on the Bloomberg U.S. Aggregate Index. Active funds outperform their self-declared benchmarks by 3% over a 36-month horizon. However, this outperformance is fully explained by their choice of benchmarks, which tend to have lower systematic risk than actual fund portfolios. When evaluated against more appropriate benchmarks identified from return correlations, bond funds underperform. Benchmark-adjusted returns strongly predict future flows, giving managers incentives to misbenchmark. Although benchmark changes are infrequent, they appear strategic: funds switch to easier-to-beat benchmarks following periods of underperformance and subsequently experience a temporary increase in flows.

zlynne@ceibs.edu