It Ain’t Just What Funds Disclose (It's The Way That They Do It)

Abstract

Financial disclosures provide more information than simply their regulated content. Disclosure tone and textual attributes affect firm performance, earnings persistence, stock volatility, capital costs, and retail investor behavior. But do these theories apply to mutual fund disclosures? In this Article, we examine the extent to which disclosure tone predicts fund risk and performance. Following Loughran & McDonald (2011), we develop customized dictionaries specific to mutual funds. We then introduce a novel sentiment scoring framework that generates a transparent sentence- and disclosure-level score for our sample of 132,326 mutual fund summary prospectuses (497k) from 2010-2018. Descriptive analysis validates our dictionary by showing meaningful and statistically significant differences across disclosure sections, CRSP categories, and time. Principal risk (PR) sections are more negative (and uniformly so) than investment strategy (IS) sections across time. Using a fixed-effects model, we demonstrate sentiment's predictive power on fund's return, volatility, and portfolio composition, conditional on sentiment’s relationship with readability. Our context-sensitive approach provides researchers and regulators with a tool to better assess not only what fund disclosures are saying, but how they say it. Further, our results reveal persistent differences in PR and IS estimated information signals that map onto content regulations and suggest a rich field for future research.