Mutual Fund Misclassification: Evidence Based on Style Analysis

An iterative application of William Sharpe's method of style analysis is applied to the classification of equity mutual funds. A new methodology for creating purified mutual fund style indexes is used to verify existing classifications. Results suggest that 9 percent of all equity funds are seriously misclassified and another 31 percent are somewhat misclassified. Two factors emerge as the most likely reasons for misclassification: (1) the ambiguity of the current classification system and (2) competitive pressures in the mutual fund industry and compensation structures that reward relative performance. Monte Carlo simulations on out-of-sample data show that this misclassification has a significant effect on investors' ability to build diversified portfolios of mutual funds.