Star Creation: The Incubation of Mutual Funds

Mutual fund incubation is a process by which new funds are initially operated out of public view. The high-performing funds are then marketed to investors, and the low-performing funds are quietly terminated. This selection process is not revealed to investors, thus creating the illusion that the successful funds' returns were the result of skill rather than luck. Also, some fund companies subsidize their incubator funds in ways that do not continue after the funds are sold to the public.

As a result, the high returns of successful incubator funds generally do not persist after the funds are marketed to investors. We argue that incubation is a misleading practice that must be better addressed by the SEC. Although SEC rules prevent marketing of funds based on pre- registration performance, the SEC permits companies to engage in post-registration incubation without disclosing to investors the selection process or the typical lack of performance persistence. In addition, the SEC permits funds to selectively use performance data from predecessor and similar funds and private accounts without disclosing the selection process. We recommend greater disclosure, or outright prohibition, of fund incubation and similar deceptive practices.