Watch Out for Fairy Tale Returns

Richard Evans first heard the word “incubation” while a Ph.D. student at the Wharton School. As part of his dissertation, he sought to understand how some mutual funds generated fantastic returns but weren’t open to the public for investing. He called one of the investment management companies running the funds to inquire.

The company told him the funds were incubating, an answer that launched a curious graduate student into landmark research that would bring light to a murky corner of the mutual-fund world. In time, Evans discovered that only the highest-performing incubating funds would be open to the public. Their target? The mom and pop investor. The returns? Unbelievable — as in a fairy tale.

Evans says the story of how incubating funds work teaches caution to investors. “The best solution to these types of problems is not regulation; rather, it’s to help the investor make good decisions, to teach people the right metrics.”

Evans, a Darden School of Business professor whose research deals broadly with investment decisions, says that “retail investors tend to pay more attention to good historical returns.” Past performance, however, doesn’t tell you much at all, a disclaimer that every fund shares with investors.

But some investors — especially less sophisticated ones — gravitate to past performance. And so evolved the clever strategy of incubation, in which mutual funds are managed quietly — and in private — for several years, using the money from the fund family itself.

“The funds are essentially private because they don’t have tickers and often aren’t reported to Morningstar, CRSP, Lipper or other mutual fund data providers until the fund sponsor is ready to open them to the public,” Evans says.

But incubating funds can’t be kept totally secret because in order to use a “track record” to promote a fund, the performance has to be filed with the SEC. That’s where Evans unearthed the information he needed.

Because the funds are hidden from the general public and the funds are essentially using house money, fund managers can invest in riskier assets and have more concentrated portfolios, increasing the odds that one or two funds will show great returns. Money also doesn’t flow in and out of incubating funds — unlike public funds — simplifying the financial landscape and increasing their odds of higher returns.

Eventually the fund managers pluck those few incubated funds with the best returns to offer to the public and “kill off” the many funds which failed to produce good returns. That selective reporting makes the chosen funds look like much better investments than they are, says Evans. “Even if each fund’s performance is random, if you start enough funds, at least one of them will be good,” he says. “You take 10 funds, one is going to hit.” In other words, the fund manager, using incubation, contrives the return.

For example, one privately owned investment management firm set up a dozen or so funds to percolate in incubation. The historical returns reached an astonishing 30 percent for one of those funds. Investors mesmerized by the huge return flocked to the heavily publicized fund without understanding it was incubated, says Evans. The fund’s overall performance, once in public, was mediocre. But investors stuffed the fund with over $2 billion in assets.

“Funds in incubation outperform nonincubated funds by 3.5 percent, risk-adjusted, and when they are opened to the public they attract higher flows,” says Evans. “Post-incubation, however, this outperformance disappears.”

Evans did the first major study on mutual fund incubator bias. The study covered a 10-year period from 1996 to 2005. In summary, he found:

• Managers incubated almost 25 percent of new funds.
• Incubated funds attracted higher net-dollar flows, as the public believed these were superior funds.
• The outperformance disappeared post-incubation.
• The performance reversal imparted an upward bias to returns that was difficult to correct.
• The bias resulted in risk-adjusted alphas being overstated by 0.84 percent on an equal-weighted basis.

“The bottom line is that many fund families are creating fairy tales to intentionally mislead investors,” he says. “While most funds’ prospectus disclosures include a statement that past performance is not related to future performance, for incubated funds past performance is related to future performance … negatively related. On average, incubated funds underperform their prior track record once they are opened to the investing public.”

But since his eye-opening findings, Evans found that some fund managers using incubation strategy have shifted to hedge funds or private investment vehicles.

So what is a smart investor to do? Stay away from funds that show a big jump in assets. That could mean the fund just emerged from incubation, he says. Evans also cautioned against about chasing past performance. “You’ll be better off buying an index fund. Keep a broadly diversified portfolio. Balance it on occasion.”

“It may be a boring way to invest, but it works.”

Carlos Santos is a freelance writer and co-author of Rot, Riot and Rebellion: Mr. Jefferson’s Struggle to Save the University that Changed America.