Incubation bias: Not just a hedge fund issue according to two law professors

It is often argued that aggregate hedge fund performance data suffers from a near-fatal flaw: since it is voluntarily reported by the manager, hedge fund indices only include funds that the managers have deemed marketable.  In 2002, David Hsieh of Duke University and William Fung of London Business School wrote a seminal article on this issue called “Benchmarks of Hedge Fund Performance: Information Content and Measurement Biases.”

In contrast, regulations often require mutual funds to register with securities authorities before they can begin to assemble a track record.  As a result, mutual fund data is assumed to be free of such bias.

But as Alan Palmiter and Ahmed Taha, law professors at Wake Forest University write in a forthcoming article for the Vanderbilt Law Review called Star Creation: The Manipulation of Mutual Fund Performance Through Incubation“, the requirement for a mutual fund to register does not eliminate the problems arising from so-called “mutual fund incubation.”

Observe the professors:

“…fund companies can create an incubator fund, register it with the SEC, yet not advertise nor obtain a ticker symbol for it. Thus, although the fund would technically be public because it is registered with the SEC, it would be effectively private. Without a ticker symbol, the public would be unable to buy the fund, and without it being advertised, few potential investors would know about the fund anyway.”

They are basically saying that what started out to be a clear distinction between an unregistered and a registered mutual fund has now become a gray area where a registered fund remains under wraps until the manager thinks it can effectively be marketed.

Palmiter and Taha suggest that the prevalence of funds that de-register before they are sold to the public is proof that mutual fund companies are quietly taking losing funds ’round behind the woodshed and whacking them over the head.

Winning funds, on the other hand, are given a ticker symbol and entered into (voluntary) databases such as Morningstar and CRSP.  The authors suggest that a delay between SEC registration and ticker symbol belies an incubation strategy.  They cite a 2007 study that finds 39% of mutual funds that eventually get a ticker symbol already have track records of more than a year.  Another study found that 49% of Morningstar-listed mutual funds reported at least a year of pre-existing returns.

Research shows that the survivors of this post-registration/pre-marketing “incubation” phase tend to be the ones with higher performance.  However,

“Although during their incubation period, incubator funds that are eventually taken public outperform comparable funds, they generally do not continue to do so afterward. The same studies that identify high incubation-period returns generally find lower returns once these incubator funds are sold to the public.”

The authors cite several reasons for the out-performance of incubated funds.  First, they say that fund companies give incubating funds “special treatment” such as giving them an over-allocation of IPOs or a lower share of overhead expenses.  But the most obvious is the propensity to only bring top performing funds to market (or, at least to bring top performing funds to market more quickly).

Given these conclusions, you can guess that Palmiter and Taha are advocates of stronger SEC oversight of mutual fund incubation.  The problem, they say, is that “incubation” has no regulatory definition.  While the SEC prevents the usage of pre-registration returns in marketing, it has little to say about the use of post-registration/pre-marketing returns.

Still, the SEC does prevent the creation of funds simply to provide sweet track records for marketing.  However, the authors argue that other loop-holes allow fund companies to borrow track records from separate accounts and predecessor funds – providing savvy marketers with more than enough track-record options.

The bottom line, argue Palmiter and Taha, is that the SEC should require funds to disclose:

  1. any fee or expense subsidization
  2. any overallocation of IPOs
  3. the size of the fund when it generated the reported returns

To prevent fund companies from cherry picking its best incubated funds, they also propose a disclaimer such as:

“This fund was selected to be marketed by its sponsor from a number of other new funds it operates, many of which did not have as high returns. Studies show that a new fund’s strong initial performance usually does not persist. A new fund’s performance is often a matter of chance.”

When the SEC first required funds to register in 1933, the objective was to move funds into the public domain for all to see.  But with tens of thousands of different funds today, public awareness lies in the hands of Morningstar, CRSP and those who assign ticker symbols, not necessarily with the SEC.

So it appears that one of the most often cited complaints about hedge fund data might also apply to mutual funds as well.

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