Star Creation:
Incubation of Mutual Funds
Alan Palmiter & Ahmed Taha
Wake Forest – Law School WIP
March 4, 2008
US mutual fund market
Mutual Fund Ownership - US stocks
30%
25%
20%
15%
10%
5%
0%
1950
1960
1970
1980
1990
2000
2005
Source: Bogle / Federal Reserve Flow of Funds Accounts
Market Overview
Number of mutual funds?
Total assets?
– % U.S. stocks/bonds?
– % retirement savings?
Composition?
Number of households?
Household demographics?
– Median income?
– Median financial assets?
• Knowledge of basic
characteristics
– Asset class?
– Fund risk?
– Fund expenses?
• Persistence of past
returns
– Morningstar *****
– Asset classes?
How to create stars?
Closing out
Merger
Incubation
Selection
Incubation
(how they do it)
Parable of the “market
beating” broker
10,000
letters
5,000
letters
2,500
letters
1,250
letters
625
letters
Parable of the “market
beating” broker
10,000
letters
5,000
letters
2,500
letters
1,250
letters
625
letters
Stock picking ability
• Apparent: 97%
• Actual: 50%
Incubation
(how do you know?)
Create
Close
Register
Deregister
CUSIP
assigned
Report
M-star
Sell to
public
Finance studies
Arteaga, Ciccotello & Grant (1998)
• Funds less than 1-yr-old in MF database, compared to funds with
more than 1-yr-old in database
• New funds > established funds (about 5% for late 90s)
• But in 2nd year, “best” new funds not statistically > established funds
Wisen & Chiang (2006)
• Funds with less than 9 months of existence, compared to seasoned
funds with more than 12 months experience
• New funds > seasoned funds (3-8% better, depending on category)
Evans (2007)
• Funds with more than 1-year lag between creation and public sale
• Incubation returns > never-incubated public returns (15% better!! And
2-5% on risk-adjusted basis)
• But incubated funds < never-incubated funds (- 3.5% nominal after 3
years / nothing on risk-adjusted basis)
Ackerman & Loughran (2007)
• Funds entering MStar with 6-month+ prior returns
• Incubation returns > market returns (3.6% better than stock market)
Findings
(1) “New” funds outperform “old” funds, but
outperformance does not continue
– Evidence of incubation
– Some new “loser” funds never survived
(2) Reasons “new” funds outperform “old” funds
– Fund families allocate “hot” IPO’s to “new” funds
– Families underallocate expenses to “new” funds
– Selection bias: strong performers more likely to
be taken public
SEC approach
> Hot IPOs
> Underallocate expenses
> Selection bias
Hot IPO’s (Van Kampen Growth Fund proceeding):
• “Overcooked” new fund
– Reported and advertised 62% annual return
– Didn’t disclose that 1/3 of return was from hot IPO’s
– Once public Fund grew from ~$300K to $100 million
• Sanction:
– Fined “for failing to disclose material facts concerning the impact of hot
IPO’s on their ‘incubator’ Growth Fund's 1996 performance.”
Underallocation of Expenses:
????
Selection bias
• MassMutual: SEC allows new mutual fund to use record of
separate investment account converted into mutual fund – if mutual
fund not created for track record
• Response to Prof. Greene’s Hypothetical: SEC says can’t use
multiple similar funds to create a performance track record
• ITT Hartford: SEC allows performance of similarly managed
insurance funds’ in advertisements for new public funds.
ITT Hartford:
The fund must “prominently
disclose that the
Insurance Fund’s
performance is not the
Public Fund’s own
performance, and should
not be considered
indicative of the past or
future performance of the
public fund.”
Solutions?
#1 - More disclosure
Examples
– Must disclose # of funds not taken public
– Explanatory Warning:
“Because fund companies often take public only funds
that perform well in the past, high past performance of a
particular fund should not be taken as evidence of
managerial skill.”
Problems
– Must disclose all private accounts?
– Will investors understand?
– Will investors care?
#2: No reporting of
non-public returns
Advantages
– Doesn’t rely on investors
– Eliminates incentive to favor incubation funds
Problems
– Puts new funds at competitive disadvantage: Investors want
the information
– Circumvention: “Public Incubation”
#3: Treat “incubation”
as deceptive practice
Advantages
– Relies on courts, rather than captured SEC
– Places burden on brokers not to market “incubated” funds
– Allows some flexibility, but prevents “new broker” game
Problems
– Courts not expert in number manipulations
– May be hard to distinguish – how know whether fund is
“incubated”
The end