Mutual Fund Incubation and the Role

of the Securities and Exchange

CommissionCarl Ackermann

Tim Loughran

ABSTRACT. A mutual fund family incubates a fund

when it creates a privately subsidized fund not available to

the general investing public. It destroys unsuccessful

incubator funds. The few successful funds will report

higher incubation returns than the market return in

advertisements intended to attract money from individual

investors. This practice is currently allowed by the SEC.

The evidence is that incubation returns are not a good

predictor of subsequent fund performance and likely serve

to mislead unsuspecting investors.

KEY WORDS: mutual funds, incubation, Securities and

Exchange Commission

There are over 20,000 mutual funds to choose from.

In the U.S., there are now more mutual funds

investing in stocks than there are companies listed on

the New York Stock Exchange (NYSE), the

American Stock Exchange (Amex), and Nasdaq

combined. Deciding which mutual fund to invest in

can be a daunting task for an individual investor.

The typical U.S. equity mutual fund pools money

from many different investors to purchase shares of

publicly traded companies. Managers of mutual

funds receive fees from investors in return for

running the fund. Mutual funds may have different

investment styles, such as growth, value, small-cap,

or large-cap (see Brown and Goetzmann (1997) for a

discussion of mutual fund style categories).

The common starting point in selecting a new fund

is examination of the fund’s past return relative to the

market return as reported in the prospectus. Mutual

fund company advertisements often focus entirely on

past performance over the market to entice investors.

Research by Warther (1995) and others has shown

that investor cash flows to funds are directly tied to

their past relative performance. Mutual funds with

abnormally good performance see money flow their

way; underperforming funds often see money out-

flows as investors follow managers with ‘‘hot hands.’’

Mutual fund families may experiment with dif-

ferent trading strategies or investment managers be-

fore they offer a product to the investing public.

Funds not open to investment by the general public

are called incubator funds. Unsuccessful funds in terms

of realized returns relative to the market are not

offered to the general public, but rather are elimi-

nated by the mutual fund family (see Evans, 2004).

The poor realized returns and strategies are generally

unreported. Well-performing incubator funds are

opened up to the general public, which is often at-

tracted by new investment strategies and outstanding

past performance.

A hypothetical example can demonstrate the po-

tential misuse of incubator returns. Suppose we

allocate $50,000 to 100 different kindergarten stu-

dents for each to create an investment portfolio

(similar to an incubator fund). The students are asked

to randomly select about 10 publicly traded stocks to

form the investment portfolio.

University of Notre Dame Finance Professor Carl Ackermann

received a Bachelor of Arts from Amherst College and a

Ph.D. from the University of North Carolina (Chapel Hill).

University of Notre Dame Finance Professor Tim Loughran

received a Bachelor of Arts and a Bachelor of Science from the

University of Illinois (Urbana), an MBA from Indiana

University, and a Ph.D. from the University of Illinois

(Urbana).

Journal of Business Ethics (2007) 70:33–37 � Springer 2006DOI 10.1007/s10551-006-9081-x

Over 3-month, 6-month, or 1-year investment

windows, the average return for the kindergartener-

run portfolios would not be expected to beat the

returns of a major stock market index. Just by luck

though, a few of these children might do quite well

in terms of realized portfolio returns relative to the

market. Now, since the children selected the names

of the companies randomly, we would not expect

those few successful portfolios to continue to out-

perform the stock market going forward.

We do not expect past performance to predict

future performance in mutual funds either. With

millions of investors scouring the stock market for

profit opportunities, it may be difficult for a mutual

fund manager to consistently find bargains. Carhart

(1997) and others show that performance persistence

is not detectable in mutual funds.

The same principle applies for incubated mutual

funds. It has to do with self-selection. If only the

successful funds are offered to the public, while the

randomly unsuccessful funds are destroyed, why

would the past performance of incubator funds be a

good predictor of subsequent return performance?

The protector of individual investors is the

Securities and Exchange Commission (SEC). Its

primary mission is to ‘‘protect investors and maintain

the integrity of the securities markets.’’ The SEC

states on its website that ‘‘only through the steady

flow of timely, comprehensive and accurate infor-

mation can people make sound investment deci-

sions.’’

In the case of incubator funds, are the reported

returns biased? Is the past performance of incubator

funds a reasonable proxy for their return once a fund

is opened to investing by the public?

We will show that the past performance of

incubator funds is indeed a poor proxy for the re-

turns that the general public receives once a fund is

opened up to investors. Results for a unique sample

of 95 U.S. equity mutual funds during 2000–2003

indicate that incubator funds have higher returns

than the Center for Research in Security Prices

(CRSP) value-weighted NYSE/Amex/Nasdaq

stock market return for various periods before a fund

entered the Morningstar fund database. Value-

weighted returns are created by multiplying and

summing each firm’s stock return by its proportional

weight in the index. Thus, larger capitalization

(stock price multiplied by shares outstanding) firms

have a bigger proportional weight in the CRSP

value-weighted Index.

Table I reports the number of mutual funds in the

sample. The last two columns report the percentage

of entering funds that are internet funds and

large-capitalization blend funds.

Each January of 2000–2003, we examine

Morningstar for new domestic equity mutual fund

listings. Morningstar is a widely used independent

research provider of mutual funds; it serves over

4 million investors and 140,000 professional advis-

ors. All the added mutual funds have some incubator

returns. As an example, all of the 14 mutual funds

entering the Morningstar database in January 2000

had a monthly return for December 1999.

The back-filled or incubator returns occur when

monthly returns are entered into the Morningstar

system before the fund was opened to the general

public. These are the returns that occurred when the

fund was a privately held incubator fund.

Interestingly, the number of back-filled returns

varies greatly. While five funds report only one

back-filled monthly return, one fund (Stonebridge

Aggressive Growth) reports 167 months of incu-

bated returns (almost 14 years).

Not surprisingly, as the stock market reached new

heights propelled in part by the gigantic returns of

internet companies, internet funds were introduced

to meet investor demand. In 2000 (Nasdaq hit its

record high in March 2000), over 14% of all equity

funds added were internet funds. As the internet

bubble burst, the number of new internet funds had

TABLE I

Time series of incubation mutual funds

Calendar

year

Number

of funds

% Internet

fund

% Large-cap

blend fund

2000 14 14.3 0.0

2001 29 6.9 17.2

2002 34 2.9 26.5

2003 18 0.0 33.3

Total 95 5.3 21.1

Each January, 2000–2003, funds that initially appear in

Morningstar’s database are included in the sample (only

U.S. equity mutual funds). All funds have at least 1 month

of back-filled returns before entering the Morningstar

database.

34 Carl Ackermann and Tim Loughran

dropped to 0 by 2003. Large-cap blend funds proxy

for the Standard & Poor’s (S&P) 500 Index. In 2000,

when the S&P 500 Index was doing well, but not as

well as the Nasdaq Index, there were no large-cap

blend funds added. Yet in 2003, when the S&P 500

Index outperformed the Nasdaq market, one-third

of all equity funds added were large-cap blend funds.

In untabulated results, we observed that in cal-

endar years with strong stock market performance,

there were few new bond mutual funds. Yet once

bonds started to outperform the stock market, the

number of newly added fixed-income funds rose

dramatically. Clearly, mutual fund introductions are

often timed to respond to investor interest.

Table II reports buy-and-hold mutual fund re-

turns versus the value-weighted stock market index

over various time periods. Buy-and-hold returns

represent the change in price of the mutual fund

over the specified time period. A buy-and-hold re-

turn is the actual return that an investor would re-

ceive if the mutual fund was purchased and then

held until a future date. Back-filled (or incubator

returns) are reported in Panel A; subsequent returns

once the fund enters the Morningstar database are

reported in Panel B. The first back-filled monthly

return is reported in Panel C (all the mutual funds

reported at least 1 month of back-filled returns). The

mutual fund sample starts at 95 funds and declines to

47 during the 1-year horizon due to the length

of the back-filling. Funds are included in the buy-

and-hold calculation only if the fund has the

specified number of back-filled monthly returns.

Only 47 of our sample of 95 mutual funds report a

complete year of incubation returns.

The first row of Panel A reports that the 95

mutual funds had an average return of 3.27% in the

month before entering the Morningstar database.

Over the same time period, the average return for

the CRSP value-weighted market return was 1.48%.

The difference between the mutual fund return and

the market return is 1.79% (or 179 basis points).

The last column in Table II reports the signifi-

cance level for the return difference. In the case of

the 1-month return in Panel A, the t-statistic is a

highly significant 3.22. Hence, we can easily con-

clude that the incubator mutual funds outperformed

the broad market index in the prior month.

In all the various time periods, Panel A indicates

that the incubator mutual funds had higher returns

than the CRSP value-weighted index. The greatest

return difference is over the 1-year holding period

(358 basis points), the smallest is over the 6-month

period (76 basis points).

Panel B of Table II reports average performance

after funds were added to the Morningstar database.

We include performance figures through the last

reported monthly return, even if a fund merged into

another fund or liquidated.

Only in the first month does the average mutual

fund outperform the value-weighted market index.

TABLE II

Back-filled versus subsequent mutual fund returns

Buy-and-hold

time period

Sample size Mutual fund return

(1) (%)

CRSP VW-Index

return (2) (%)

Return difference

(1) ) (2) (%)

t-stat

Panel A: back-filled returns

1 Month 95 3.27 1.48 1.79 3.22

3 Month 87 6.99 5.50 1.49 0.98

6 Month 69 )4.38 )5.14 0.76 0.50

1 Year 47 )1.47 )5.05 3.58 1.02

Panel B: subsequent returns

1 Month 94 0.21 )0.39 0.60 1.41

3 Month 93 )3.88 )3.78 )0.10 )0.10

6 Month 88 )5.20 )3.79 )1.41 )1.10

1 Year 85 )10.50 )6.27 )4.23 )2.14

Panel C: first reported back-filled monthly return

1 Month 95 2.19 1.17 1.02 1.77

Mutual Fund Incubation 35

As the buy-and-hold period lengthens, funds

underperform more. The 85 funds with one com-

plete year of subsequent returns turned in poor

performance relative to the market; with an average

return of – 10.50% compared to – 6.27%. The dif-

ference of 423 basis points is both economically

important and statistically significant.

One can see that taking past incubator returns as a

predictor of subsequent performance relative to the

market is a very poor idea. The average incubator

fund outperformed the market by 358 basis points in

the prior year, and then underperformed the market

by 423 basis points in the next year. This is a stun-

ning swing in relative performance over a relatively

short 2-year window.

The last panel of Table II reports the first available

monthly fund return on the Morningstar database,

no matter when the return occurs. As noted earlier,

five funds report only the December 1999 monthly

return before they enter the database in January

2000; other funds report years of prior return per-

formance. Incubator funds have the ability to select

the starting point in their return series, since they are

free to choose their first month of reported perfor-

mance. We therefore suspect that the initial month

will show abnormally high performance as well.

Panel C reports that the first incubated monthly

return is 2.19% compared to the market return of

1.17%. The 102 basis point return difference is sig-

nificant at the 10% level. So, not surprisingly, those

mutual funds self-report strong prior performance

that appears to be a poor proxy for what investors

receive once the funds open up to the general

public. This evidence is consistent with the results of

Elton et al. (1989) for publicly traded commodity

funds.

It is well known that individual investors focus on

past performance when they pick a mutual fund.

And our limited pilot study shows a strong and

negative relationship between incubator fund returns

and the subsequent returns generated. While the use

of incubator returns in a prospectus is legal, such

reports could certainly mislead individual investors

into believing that the strong returns will continue

to the future.

We believe that some mutual fund families use

incubator returns in the prospectus to intentionally

mislead investors. The use of incubator returns is

different than a firm showcasing its best products,

because the fund returns are unlikely to be dupli-

cated in the future. A pharmaceutical product that

works well in clinical trials will likely be successful

once the product is offered to millions of consumers.

However, as shown in our paper, incubator returns

generated without widespread investor ownership

are unlikely to persist.

We think that investors would be better off if

incubator returns were not permitted in the pro-

spectus. That is, no information is better than mis-

leading information for the typical investor. An

investor could still decide whether to purchase a fund,

based on its investment style, trading strategy, man-

agers, or the historical performance of the fund family.

Incubator funds create a perception that all

investors don’t play on a level playing field.

Sophisticated investors can see through the use of

incubator returns while the typical retail investor can

easily be fooled into thinking that the generated

returns are an accurate predictor of future perfor-

mance. If the typical retail investor removes money

from financial markets due to a lack of confidence,

society is hurt. A well-functioning capital market

needs all types of investors to provide liquidity.

Perceptions of an uneven playing field hurt the

credibility and performance of the financial markets.

One might argue that investors (i.e., buyers)

should beware. That is, individual investors should

take the responsibility to do the proper research

prior to purchasing mutual funds. Yet, the concept

of incubator returns is too complicated for the typ-

ical investor.

Why has the SEC remained on the sidelines

concerning the use of incubator returns? That the

SEC has been quiet on this issue may lead retail

investors to believe that there are no ethical issues

relating to the use of incubator returns. Obviously,

the presence of the SEC does not absolve either

investors or fund companies from responsibility.

Investors have the responsibility to carefully inves-

tigate the risk characteristics of the mutual fund.

Likewise, mutual funds have the responsibility to

accurately inform investors about past performance

and fund strategies.

It is not as if the potential misuse of incubator

returns has escaped attention. In a major address at

the Mutual Fund Regulation and Compliance

Conference in May 2004, John Bogle, founder of

the Vanguard Group, advised that the SEC ‘‘ought

36 Carl Ackermann and Tim Loughran

to have a zero tolerance policy toward illusory re-

cords that are manufactured out of thin air.’’ He is

absolutely correct.

The inescapable policy implication is that the SEC

should be vigilant in overseeing the dissemination of

information concerning past fund performance and

not allow mutual funds to report, in any manner,

returns generated during an incubation period. Only

mutual funds that are widely available to the general

public should be allowed to report prior return

performance. Although we know it is foolish to

believe that past fund returns are an accurate pre-

dictor of subsequent returns, investors who tend to

think this are exactly the ones that the SEC is

charged with protecting. The typical individual

investor would not be aware of the use or the def-

inition of incubator returns.

As noted earlier, one of the main goals of the SEC

is to disseminate accurate information for use by the

investing community. By allowing some mutual

fund families to mislead investors through the use of

incubator returns, the SEC has failed in one of its

fundamental goals. This creates the impression that

the government is not interested in properly or

accurately disseminating past return information.

One area of future research is to examine whether

or not the misuse of incubator returns harms the

credibility of mutual fund families that engage in the

practice for short-term financial gains. If the SEC

cannot ban the use of misleading incubator returns in

mutual fund prospectuses, can investors somehow

penalize mutual fund families for unethical behavior?

Houge and Wellman (2005) report that mutual

funds that came under investigation for illegal trad-

ing practices experienced a substantial drop in assets

under management in the 6 months following the

investigation announcement. Since more assets un-

der management means more fee income for a

mutual fund, a drop in assets is a sure-fire way for

investors to signal disapproval of current managerial

practices.

It would also be interesting to track the perfor-

mance of the incubator funds in the future, not only

to determine which incubator funds are most suc-

cessful in attracting new money, but how the

(under)performance of incubator funds leads to

investment in other funds within the same family.

What can we conclude about the SEC’s slow

moving nature? Does it investigate misleading or

unethical behavior by mutual fund families only after

the popular press exposes the action? In an arcane

return area, the SEC may address the issue only if

others force its hand. These are interesting questions

for future research.

Acknowledgements

We would like to thank participants at the 2005 Uni-

versity of Notre Dame Ethical Dimensions in Business

Conference, a referee, and Ann Tenbrunsel (editor) for

helpful suggestions.

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Carl Ackermann and Tim Loughran

Mendoza College of Business,

University of Notre Dame,

Notre Dame, IN, 46556-5646,

U.S.A.

E-mails: Ackermann.1@nd.edu; Loughran.9@nd.edu

Mutual Fund Incubation 37