Bryan Binkholder Discusses Incubator Funds – Another Variation of the Mutual Fund Deception
Most of you by now have heard me talk about the ridiculousness of chasing past performance when it comes to mutual funds. Not only does past performance have absolutely zero bearing on the future earnings of a fund, but most of the past performance statistics are created, manipulated, or falsely produced and cleverly reported to the believing investor, who is all too eager to hop on the bandwagon of the next “sure thing.”
Since investors continue to rely on and respond to heavy advertising focused on past performance, fund sponsors have a great incentive to create and market funds with a record of strong returns. Keyword here is “create.” And why wouldn’t they? If you’re still buying the lie, they’d be foolish to change their strategy. A variety of methods are used to manufacture these funds, including incubation.
Incubation of Mutual Funds
Fund incubation can be defined as the process of creating funds hidden from the public eye and then selling only the strong performers to the public. Through fund incubation, companies can create funds with misleadingly high returns, often by subsidizing them to create highly superior (although completely deceptive) performance records. Unfortunately for the investor, incubator funds don’t continue to perform after they are sold to the public. Let’s look at the process.
How Does Fund Incubation Work & How Can You Spot One?
Typically, a small amount of seed money is supplied by a fund company to create an investment fund. The fund “incubates”, either privately or publicly, for a period that can last anywhere from a few months to a few years. At some point the fund company decides whether to terminate the fund or market it to the public. Obviously, this decision is based on performance. If terminated, all record of the fund’s existence is swept under the rug and only high-performing funds are offered to the public.
Of course, the key to any successful scam is to keep everything as vague and as difficult to pinpoint as possible. Fund incubation is no different. There are several tell-tale signs of fund incubation, but of course, the average investor isn’t even aware of its existence, so sniffing out an incubated fund is not a huge concern to fund companies.
A couple of strong indicators of incubation would include:
- Extended Lag Between Inception and Obtaining a Ticker Symbol – Fund sponsors can register a fund but keep it unavailable to the public, simply by not seeking a ticker symbol. The fund is technically legal to be sold, but cannot be bought without a ticker symbol. This tactic is widespread. 23% of domestic equity mutual funds that began after 1996 and received a ticker symbol by January 2006 had more than an entire year lag between inception and ticker. 10% had over a two year lag.
- Not Reporting – Another method to keep out of the public view is for registered funds to simply fail to report their existence to data providers, such as Morningstar or to the Center for Research in Securities Prices. Data providers don’t seek out information, but instead, rely on fund sponsors to notify them when a new fund is created. How convenient.
What Difference Does it Make if a Fund Was Incubated?
Realistically, if a fund continued to perform after it was offered to the public, it would be different, but they do not. The fact of the matter is that funds are created to “appear” as if they have had a long and healthy public track record, when in reality, they were not actually offered to the public at all. Creative tactics, such as registering the fund but not seeking a ticker symbol causes them to appear publicly available while actually in the incubation period, where the fund’s performance can be manipulated and ultimately grossly misrepresented to you, the investor.
How much can they be manipulated? According to a report compiled by the Vanderbilt Law Review, which includes the well documented findings of Carl Ackermann and Tim Loughran (2007 research study in the Journal of Business Ethics) incubator funds with at least a 12 month lapse from inception to receiving a ticker symbol have an average higher performance of up to 9.8% during the incubation period than non-incubated funds do during their own first three years of operation.
Ackermann and Loughran defined incubation period returns as those occurring before the fund is reported by Morningstar. So, with this in mind, what you’re reading in Morningstar to help you make important investment decisions is very carefully and purposefully reported. You’re definitely not getting the entire picture.
Once They Go Public The Performance Quickly Plummets
Although these incubated funds outperform comparable funds before going public, this is not the story afterward. The same studies that found high incubation-period returns also identified a significant drop once the funds were sold to the public.
While the returns during incubation were 9.8% higher (annualized), they were shown to drop to a 3.2% LOWER return than non-incubated funds during their own first three years of existence.
Another study, by Arteaga, Ciccotello, and Grant involved aggressive growth funds. In the study, the researchers identified five mutual funds as incubator funds and traced them back to the exact dates they began operations and were offered publicly. These five incubated funds outperformed the S&P 500 by 8% annualized during the incubation period, but underperformed by 4% once opened to investors.
Bottom line? Funds that boast this stellar past performance are often simply reporting manipulated numbers to lure investors which will certainly not continue once the funds are opened to the public.
Why Don’t Investors Catch On?
So, with all this misleading and “carefully unmentioned” information, you’d think that investors would be less likely to buy into vague advertisements. Not so. A recent experiment involving three different advertisements with three different types of information proved this point.
Here’s the specs:
Each version of the advertisement highlighted the strong past performance of two of the company’s growth funds.
- Variation A – Noted that the advertised funds were only two of the company’s 30 funds.
- Variation B – Stated that these were the company’s only two funds.
- Variation C – Did not state how many funds the company had.
When participants in the experiment were asked about the three companies they rated Variation A lower than the others and were less willing to invest. In other words, if the ratio is two out of thirty well performing funds, the company didn’t seem very credible. On the other hand, participants who saw the advertisement that left out this information completely viewed it with the same amount of trust and enthusiasm as the company who only had two funds.
These results show that unless the information is provided, investors are more willing to blindly view a company in the best light possible.
So, in reality, there is a mixture of abuse (from the fund companies) along with the willingness to be abused. The SEC has taken little action to properly inform or protect investors from these tactics.
I’m obviously not the first person to bring these findings to light, but unless investors are determined to educate themselves and refuse to continue down this path to financial ruin, it’s unlikely that things will change.
Bryan Binkholder, The Financial Coach, is a catalyst for change in the financial industry. With a true passion to make a difference, Bryan offers practical insights on financial topics, investment strategies, and business success. As a business advisor, motivational speaker and author, Bryan is best known for exposing the inner workings of Wall Street and bringing clarity to common investment misconceptions. Be sure to take advantage of his two most popular resources: 7 Deadly Traps of Investing and The Six Pitfalls of Retirement Planning and look for his latest book, 401(k) Conspiracy, authored with Jim Winkelmann of Blue Ocean Portfolios. If you are a business owner, plan sponsor, or 401(k) plan participant, you’ll want this information.