The cost of misclassification in mutual funds

Fei Fang and Sitikantha Parida

Finance Research Letters, 2025, vol. 78, issue C

Abstract: In March 2020, Morningstar revised its Low Carbon Designation (LCD) methodology. Before this revision, U.S. mutual funds were categorized into two groups: those meeting low-carbon thresholds (labeled as LCD funds) and those that did not (non-LCD funds), which were perceived as high-carbon funds. Crucially, many funds lacking available carbon metrics were not categorized separately from non-LCD funds, resulting in their misclassification and the mistaken perception of being high-carbon funds. The updated methodology introduced a third category—missing rating funds—to represent funds for which the LCD could not be determined. Our analysis reveals that the failure to distinguish missing rating funds from non-LCD funds resulted in approximately $21.3 billion in lost flows to these funds compared to LCD funds over the three months preceding the revision. After the change, these previously misclassified funds experienced a significant recovery, attracting approximately $15.6 billion more than non-LCD funds within three months. Our findings highlight the substantial financial consequences of fund misclassification. They also reveal that investors respond strongly to fund ratings, even when inaccurate, suggesting a preference for ratings over underlying information.

Keywords: Mutual fund flows; Morningstar low carbon designation; Fund misclassification (search for similar items in EconPapers)
JEL-codes: G11 G18 G23 G28 Q54 (search for similar items in EconPapers)
Date: 2025
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finlet:v:78:y:2025:i:c:s1544612325003381

DOI: 10.1016/j.frl.2025.107074

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