Do Mutual Funds Walk the Talk? A Textual Analysis of Risk Disclosure by Mutual Funds

Abstract

Do risk disclosures by mutual funds reflect funds’ actual investment risks? Using textual analysis, we examine risk disclosures in funds’ summary prospectuses to determine whether funds do accurately disclose their risks. We first document the types of risks disclosed by funds and study the relation between fund-disclosed risks and risk factors documented in academic studies. We find that most disclosed risks can be linked to meaningful and well-known academic risk factors. In our main tests, we develop fund-level measures to evaluate the informativeness of funds’ risk disclosure, including risk coverage, conciseness, and uniqueness. Our findings suggest that disclosed risks in general reflect a large proportion of funds’ investment risks but with substantial cross-fund heterogeneity. Younger funds, larger funds, riskier funds, funds with higher expense ratios, and funds with inferior performance tend to make more comprehensive disclosures. Interestingly, we find that funds tend to overdisclose risks; half of the disclosed risks are not significant in explaining the variations in fund returns. Further tests show a negative and significant relation between risk coverage and subsequent fund performance. However, new money flows are not related to risk coverage. Finally, we document some evidence that funds disclose their risks in a timely manner.