Showcasing Lucky Stars: Mutual Fund Incubators

In 2012 the mutual fund industry launched 628 new funds.  This number wasn’t a record, it was simply in-line with average figures. Almost 500 funds were either liquidated or merged away into other funds. This pattern repeats year after year: new funds get launched, poorly performing funds disappear. In bad markets, the industry rushes to make funds disappear, with 869 funds closing in 2009 after a terrible bear market.

From ici.org

From ici.org

But this is only part of the story. Mutual fund companies have a method of “soft launching” funds, typically called “Incubator” funds.  Here’s how it works:

1) A fund company files SEC registration for 10 new mutual funds.  This allows them to later publish a verifiable track record,

2) Rather than opening the funds to public investment, funds are seeded with company capital, manager money and private offerings,

3) After several years, one or two of these ten funds has beaten its index by sure luck. This “winning” fund is now touted to the public as a wonderful new option for their portfolios.

4) The super-majority “losing” funds are quietly liquidated or merged away, and the track records with them.

5) The fund company now appears to only launch great funds!

Of course, if this were true, these same fund companies wouldn’t need to close/liquidate/merge away 500 mutual funds every year. Even more, it is easy to “jiuce up” these small incubator funds with thinly traded small cap stocks and IPOs and take a big gamble.  If the fund loses the gamble, it disappears.  If it wins, great! Now it can go public and attract millions of investor dollars.

This is worse than survivorship bias, this is paying thirty guys in Atlantic City to bet on black five times in a row, then holding up the two guys who won every time as the best roulette players in town while quietly pushing the other 28 out the back door.

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