Star Creation:Incubation of Mutual Funds

Alan Palmiter & Ahmed TahaWake Forest – Law School WIP

March 4, 2008

US mutual fund market

Mutual Fund Ownership - US stocks

0%

5%

10%

15%

20%

25%

30%

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?

Incubation

Selection

Merger

Closing out

Incubation (how they do it)

Parable of the “market beating” broker

10,000letters

625letters

1,250letters

2,500letters

5,000letters

Parable of the “market beating” broker

10,000letters

625letters

1,250letters

2,500letters

5,000letters

Stock picking ability• Apparent: 97%• Actual: 50%

Create Sell to

publicCUSIP

assignedRegister DeregisterClose

Incubation(how do you know?)

ReportM-star

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