Star creation: The incubation of mutual funds

Vanderbilt Law Review

Volumn 62, Issue 5, 2009, Pages 1483-1534

  Palmiter, Alan R ^b   Taha, Ahmed E ^a  

^a WAKE FOREST UNIVERSITY   (United States)

^b NONE

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[No Author keywords available]

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EID: 72749101432     PISSN: 00422533     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (236)

1. For a version of this story, see DANIEL R. SOLIN, THE SMARTEST INVESTMENT BOOK YOU'LL EVER READ 45-46 (2006).
2. Securities and Exchange Commission, Invest Wisely: An Introduction to Mutual Funds, (July 2, 2008), http://sec.gov/investor/pubs/inwsmf.htm.
3. Invest Wisely: An Introduction to Mutual Funds (2008) http://sec.gov/investor/pubs/inwsmf.htm Id.
4. Invest Wisely: An Introduction to Mutual Funds (2008) http://sec.gov/investor/pubs/inwsmf.htm Id.
5. Invest Wisely: An Introduction to Mutual Funds (2008) http://sec.gov/investor/pubs/inwsmf.htm Id.
6. Invest Wisely: An Introduction to Mutual Funds (2008) http://sec.gov/investor/pubs/inwsmf.htm Id.
7. INVESTMENT COMPANY INSTITUTE, 2009 Investment Company Fact Book 9 fig.i.i (49th ed. 2009), available at http://www.icifactbook.org/pdf/2009-factbook.pdf [hereinafter 2009 Fact Book].
8. Id. at 11 fig. 1.4.
9. Id. at 15 fig.1.9.
10. Id. at 21 fig.2.2.
11. Vanguard Mutual Funds, https://personal.vanguard.com/us/ FundsStocksOverview? Entry=Homeoffer01 (last visited Sept. 12, 2009) (listing current Vanguard funds)
12. All Fidelity Funds Daily Pricing, http://personal.fidelity.com/products/ funds/frameset8/daily-prices-frame. shtml?refpr=zffdfp03 Oast visited Sept. 12, 2009) (listing current Fidelity funds).
13. Investment Company Institute, Ownership of Mutual Funds, Shareholder Sentiment, and Use of the Internet, RESEARCH FUNDAMENTALS, at 3 fig.l (2008), available at www.ici.org/pdf/fm-vl7n6.pdf [hereinafter ICI, Ownership Trends].
14. INVESTMENT COMPANY INSTITUTE, PROFILE OF MUTUAL FUND SHAREHOLDERS 6 fig.1.3 (2009), available at http://www.ici.org/pdf/rpt-profile08.pdf.
15. Profile of mutual fund shareholders 6 (2009) http://www.ici.org/pdf/rpt- profile08.pdf Id.
16. FACT BOOK, supra note 7, at 73 fig.6.2.
17. Investment Company Institute, The U.S. Retirement Market, Third Quarter 2008, RESEARCH FUNDAMENTALS, at 11-13 figs.Ai-A3 (2009), www.ici.org/pdf/ retmrkt-update.pdf [hereinafter ICI, Retirement Market]. In addition to being in defined contribution plans and Individual Retirement Accounts, retirement assets are in annuities, government pension plans, and private defined benefit plans (i.e., traditional private pension plans)
18. Id. at 2 fig.l.
19. Investment Company Institute, Trends in Mutual Fund Investing (Apr. 2009), http://www.ici.org/highlights/trends-04-09.
20. JEREMY J. SIEGEL, STOCKS FOR THE LONG RUN 12-18, 24-27 (4th ed. 2008).
21. For a survey of these studies, see Alan R. Palmiter & Ahmed E. Taha, Mutual Fund Investors: Divergent Profiles, 2008 COLUM. BUS. L. REV. 934, 974-94 (2008).
22. Noel Capon, Gavan J. Fitzsimons & Russ Alan Prince, An Individual Level Analysis of the Mutual Fund Investment Decision, 10 J. FIN. SERVICES RES. 59 (1996).
23. Id. at 66.
24. Investment Company Institute, Understanding Investor Preferences for Mutual Fund Information 3 fig.i (2006), http://ici.org/pdf/rpt-06-inv-prefs- full.pdf[hereinafter ICI, investor preferences].
25. Ronald T. Wilcox, Bargain Hunting or Star Gazing? Investors' Preferences for Stock Mutual Funds, 76 J. BUS. 645 (2003). Beta is a measure of a fund's risk.
26. Id. at 650.
27. Diane Del Guercio & Paula A. Tkac, The Determinants of the Flow of Funds of Managed Portfolios: Mutual Funds vs. Pension Funds, 37 J. FlN. & quantitative analysis 523, 533 (2002).
28. Id. at 525. The authors used the fund's excess return (the extent to which it outperforms the S&P 500) as the measure of the fund's return.
29. Id. at 539.
30. id. at 525.
31. Erik R. Sirri & Peter Tufano, Costly Search and Mutual Fund Flows, 53 J. FIN. 1589, 1599 (1998)
32. see also Travis Sapp & Ashish Tiwari, Does Stock Return Momentum Explain the "Smart Money" Effect?, 59 J. FIN. 2605, 2607 (2004) (finding that fund flows into U.S. equity mutual funds "effectively demonstrated that fund investors appear to be chasing recent large returns ").
33. Wilcox, supra note 23, at 651.
34. Jonathan B. Berk & Richard C. Green, Mutual Fund Flows and Performance in Rational Markets, 112 J. POL. ECON. 1269, 1270 & n.l (2004) ('The relative performance of mutual fund managers appears to be largely unpredictable using past relative performance. While some controversial evidence of persistence [of mutual fund returns) does exist. it is concentrated in low-liquidity sectors or at shorter horizons.").
35. Nicolas P.B. Bollen & Jeffrey A. Busse, Short-Term Persistence in Mutual Fund Performance, 18 REV. FIN. STUD. 569, 587-588 (2004). Many mutual funds charge front-end or back-end (deferred) loads that investors must pay when they buy or sell fund shares, respectively. Also, to discourage short-term trading, many mutual funds impose fees on investors who sell shares soon after buying them. In addition, when an investor sells mutual fund shares for a gain, the investor must pay capital gains taxes. Investors who sell fund shares less than one year after buying them pay a higher capital gains tax rate than do investors who hold the shares for more than one year.
36. Keith Cuthbertson, Dirk Nitzsche & Niall O'Sullivan, Mutual Fund Performance 69 (Dec. 12, 2006) (unpublished manuscript, available at http://ssrn.com/abstract=955807).
37. James J. Choi, David Laibson & Brigitte C. Madrian, Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds 7-8 (Mar. 6, 2008) (unpublished manuscript, available at http://www.som.yale.edu/faculty/jjc83/ fees.pdf). Participants also included Harvard staff members and a small number of Wharton undergraduate students and Wharton Ph.D. students
38. Id. at 14.
39. Id. at 4, 21.
40. Id. at 4.
41. Id.
42. To the extent that an investor is focusing on past returns, the investor is focusing less on more important factors, such as the fund's costs, and whether the fund's objective and investment strategy are consistent with the investor's objectives and risk tolerance.
43. Bruce A. Huhmann & Nalinaksha Bhattacharyya, Does Mutual Fund Advertising Provide Necessary Investment Information?, 23 InYl J. bank marketing 296, 303 tbl.I (2005).
44. Sendhil Mullainathan & Andrei Shleifer, Persuasion in Finance 9-10 (Dec. 2005) (unpublished manuscript, available at http://ssrn.com/abstract- 864686).
45. Id. at fig.5. These averages were calculated by counting the percentage of equity fund advertisements each quarter that mentioned the fund's returns, and then averaging these quarterly measures.
46. In particular, they found that the correlation of one quarter lagged S&P 500 returns with the percentage of equity fund advertisements that mention past returns was 0.71 for Money and 0.74 for BusinessWeek. Id.
47. David F. Swensen, Unconventional Success: A Fundamental Approach to Personal Investment 167-169 & tbl.5.4 (2005).
48. Id. at 168 tbl.5.4.
49. Id.
50. In 1998, the Review had forty-eight total pages, 44 percent of the space was mutual fund advertisements, and 44 percent of these advertisements were performance advertisements, so there were a total of 12.1 performance advertisement pages (48 pages x.44 x.44 = 12.1) In 2003, the Review had thirty-four total pages, 16 percent of the space was mutual fund advertisements, and 36 percent of these advertisements were performance advertisements, so there were a total of 2.0 performance advertisement pages (34 pages x.16 x.36 = 2.0).
51. Prem C. Jain & Joanna Shuang Wu, Truth in Mutual Fund Advertising: Evidence on Future Performance and Fund Flows, 55 J. FIN. 937, 943 (2000).
52. But see Steven Gallaher, Ron Kaniel & Laura Starks, Madison Avenue Meets Wall Street: Mutual Fund Families, Competition and Advertising 29, 44 tbl.8 (Jan. 2006) (unpublished manuscript, available at http://ssrn.com/ abstract=879775) (finding a relationship between the past returns of fund families and the amount of advertising only for small, low-performing fund families).
53. Jain & Wu, supra note 45, at 943-946 & tbl.II.
54. Jonathan J. Koehler & Molly Mercer, Selection Neglect in Mutual Fund Advertisements, 55 MGMT. SCIENCE 1107 (2009).
55. In particular, the advertised funds' median one-year, five-year, and ten-year performance was at the 80th, 100th, and 100th percentile, respectively, of all company-operated equity funds that shared the same investment objective. The advertised funds also had a median one-year, five-year, and ten-year performance at the 79th, 88th, and 88th percentile, respectively, of all company-operated equity funds, irrespective of the investment objective.
56. Id. at 9.
57. Capon et al., supra note 20, at 66 tbl.l.
58. Jain & Wu, supra note 45, at 957 (2000).
59. Id.
60. Gallaher et al., supra note 45, at 31.
61. Richard B. Evans, Mutual Fund Incubation 7-8 (Mar. 21, 2009) (unpublished manuscript, available at http://ssrn.com/abstract=1005167).
62. Id. at 7.
63. Investment Company Act of 1940, 15 U.S.C. § 80a-8(f) (2008).
64. They found these applications for deregistration in the Dow Jones News Archive. Craig Wisen & Kevin CH. Chiang, Explaining the Initial Returns of Mutual Funds, 15 J. INVESTING 53, 54 (2006).
65. Domestic equity funds have as their objective to invest primarily in the stock of American companies. Evans, supra note 53, at 14-15.
66. Id. at 15.
67. Id. at 16.
68. The mean fund size showed similar growth, from $38.8 million during the incubation period to $146.6 million after incubation. Id.
69. Id. at 10.
70. Carl Ackermann & Tim Loughran, Mutual Fund Incubation and the Role of the Securities and Exchange Commission, 70 J. BUS. ETHICS 33, 34 (2007).
71. Id. at 35 & tbl.2.
72. Wisen & Chiang, supra note 56, at 54-55 & exh.l.
73. Id. at 54.
74. Other possible explanations are that new funds are terminated less frequently because they perform better than older funds or because fund sponsors often give a grace period to new funds before deciding to terminate them.
75. Id.
76. Evans, supra note 53, at 17 & tbl.II.
77. Id.
78. Fabian Garavito, Mutual Fund Incubation: Innovation or Marketing Tool 9 (Dec. 2008) (unpublished manuscript, available at http://ssrn.com/abstract- 1344642).
79. They compared funds' returns to the average return of the CRSP value-weighted market index over the same period. Ackermann & Loughran, supra note 61, at 35 & tbl.2.
80. Id.
81. Because only forty-seven funds in their sample had at least twelve months of back- returns, the 3.6 percent difference between these returns and the overall stock market was not statistically significant.
82. Id.
83. New large-capitalization growth funds outperformed similarly-sized, seasoned large- capitalization growth funds by 0.27 percent per month; new middle-capitalization growth funds outperformed similarly-sized, seasoned middle-capitalization growth funds by 0.85 percent per month; and new small-capitalization growth funds outperformed similarly-sized, seasoned small- capitalization growth funds by 0.70 percent per month. Wisen & Chiang, supra note 56, at 59 exh.4.
84. Id. at 56, 59 exh.4.
85. The database was compiled by the Kiplinger Investment Advisory Group. Kenneth R. Arteaga, Conrad S. Ciccotello & C. Terry Grant, New Equity Funds: Marketing and Performance, 54 Fin. Analysts J. 43, 44 (1998).
86. Id. at 46 tbl.2.
87. Id. at 45 tbl.l. The underperformance of new funds in 1988 was not statistically significant. Id.
88. Evans, supra note 53, at 18 & tbl.II.
89. Id. In addition, after incubation, the incubated funds' Sharpe Ratio - a measure of excess return per unit of risk - was significantly lower than that of the non-incubated funds. During incubation, the incubated funds' Sharpe Ratio was significantly higher than that of the non-incubated funds.
90. Id. at 17-18 & tbl.II.
91. Garavito, supra note 67, at 9.
92. Ackermann & Loughran, supra note 61, at 35 tbl.2.
93. Id.
94. Arteaga et al., supra note 72, at 45-46 & tbl.3.
95. Id. at 48 tbl.5.
96. For many reasons, a corporation's first sale of stock to the general public (i.e., its IPO) is often intentionally underpriced to ensure that the stock's price will immediately rise. Sean J. Griffith, Spinning and Underpricing: Legal and Economic Analysis of the Preferential Allocation of Shares in Initial Public Offerings, 69 BROOK. L. REV. 583, 590-623 (2004)
97. Because the IPO is offered at too low of a price, people offer to buy more IPO shares than are available; in other words, the IPO is oversubscribed. Someone who is able to buy the stock at the initial price (its "offering price") is therefore virtually assured of a profit in the short-term because the excess demand for the IPO will cause the stock's price to rise immediately after the IPO is publicly traded.
98. Id. at 593 n.29.
99. A mutual fund sponsor that receives an allocation of an oversubscribed IPO at its offering price can choose how to distribute the IPO shares among the funds it sponsors. Edward Wyatt, It's a Fund!: Bringing Up Baby Mutuals, N.Y. TIMES, Mar. 16, 1997, § 3, available at http://www.nytimes.com/1997/03/16/ business/it-s-a-fund-bringing-up-baby- mutuals.html?pagewanted=all.
100. Arteaga et al., supra note 72, at 44.
101. An IPO's first-day return is the increase in the stock price on the first day it is traded publicly. Thus, an IPO's first-day returns is a measure of degree to which the IPO is underpriced; the more underpriced an IPO is, the more its price will rise when it is first publicly traded. Wisen & Chiang, supra note 56, at 60, 61 exh.5.
102. In particular, they found that new large-cap and mid-cap growth funds' returns were approximately twice as sensitive to IPO first-day returns as were seasoned large-cap and mid- cap growth funds' returns. New small-cap growth funds' returns had approximately the same sensitivity as did seasoned small-cap growth funds' returns, with the exception of the smallest small-cap growth funds. Id. at 61 exh.5.
103. In the next section, we point out that strong incubation-period performance generally reflects good luck rather than skill. See infra Part II.B.3.b.
104. Evans, supra note 53, at 16.
105. Joseph Chen, Harrison Hong, Ming Huang & Jeffrey D. Kubik, Does Fund Size Erode Mutual Fund Performance? The Role of Liquidity and Organization, 94 AM. ECON. REV. 1276, 1277 (2004).
106. Joseph Chen, Harrison Hong, Ming Huang & Jeffrey D. Kubik, Does Fund Size Erode Mutual Fund Performance? The Role of Liquidity and Organization, 94 AM. ECON. REV. 1276, (2004). Id.
107. Id. at 1276-1277
108. Daniel C. Indro, Christine X. Jiang, Michael Y. Hu, & Wayne Y. Lee, Mutual Fund Performance: Does Fund Size Matter?, 55 fin. analysts J. 74, 744 (1999).
109. Laurent Barras, O. Scaillet & Russ R. Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas (May 1, 2008) (unpublished manuscript, available at http://ssrn.com/abstract=869748).
110. Id. at 18-19, 35 tbl.II, 36 tbl.III.
111. Id. at 2 (noting that their empirical finding of little long-run skill supports Berk and Green's long-run equilibrium theory, which predicts that funds that exhibit short-run skill will receive so much new investment that they will not be able continue to outperform other funds in the long run).
112. The bid-ask spread of a stock is "the difference between the highest bid and the lowest offer [for the stock] quoted on an exchange." Jeffry L. Davis & Lois E. Lightfoot, Fragmentation Versus Consolidation of Securities Trading: Evidence from the Operation of Rule 19c-3, 41 J. LEGAL ECON. 209, 214 n.26 (1998).
113. Garavito, supra note 67, at 13 ("[T]he incubation period allows funds to take on investment strategies that [they] would not be able to implement otherwise. The advantage of the incubation period is that. managers have a high degree of certainty, that bad temporary performance is not going to cause redemptions and the negative costs associated with it.");
114. Roger M. Edelen Investor flows and the assessed performance of open-end mutual funds 53 J. Fin. econ. 439 (1999( (estimating that providing liquidity to fund investors reduces fund returns by approximately 1.4 percent annually)
115. Garavito, supra note 67, at 13.
116. Id. at 9.
117. Similarly, Evans found that the median total risk and idiosyncratic risk - but generally not systematic risk - of incubator funds during incubation was slightly higher than after incubation and slightly higher than those of non-incubated funds. Evans, supra note 53, at 19-20 & tbl.III.
118. Garavito, supra note 67, at 11.
119. Barras et al., supra note 92, at 2.
120. Id. at 16, 35 tbl.II.
121. Id. at 35 tbl.II. Luck was accounted for using a "False Discovery Rate" approach. This approach uses the p-values associated with the t-statistics of the estimated alphas of 2, 076 mutual funds to estimate what percentage of high-performing funds are just lucky.
122. For a full description of this approach, see id. at 4-10.
123. Id. at 16. They found slightly more evidence of short-run skill: a statistically significant 2.4 percent of the funds exhibited skill over five-year periods.
124. Id. at 36 tbl.III.
125. Eugene F. Fama & Kenneth R. French, Luck versus Skill in the Cross Section of Mutual Fund Alpha Estimates (Mar. 9, 2009) (unpublished manuscript, available at http://ssrn. com/abstract=1356021).
126. Id. at 22.
127. Richard B. Evans, Does Alpha Really Matter? Evidence from Mutual Fund Incubation, Termination and Manager Change 7, 30 tbl.l (June 15, 2006) (unpublished manuscript, available at http://faculty.darden.virginia.edu/evansr/ pdf/do-mf-risk-adjust.pdf). In the study, Evans defined incubator funds as funds that both (1) had a lag between their inception date and the first time they were reported to the Morningstar and CRSP mutual fund databases (in other words, there existed an incubation period), and (2) had, during that incubation period, the fund family as its principal shareholder, owning more than 25 percent of the fund.
128. Id. at 6.
129. Id. at 7, 30 tbl.l. Interestingly, the incubated funds that were eventually sold to the public had an average annualized risk-adjusted return during their incubation period only about 2-4 percent higher (depending on the measure of risk-adjusted return) than did incubated funds that did not go public.
130. Id. This is evidence that fund sponsors understand that investors pay little attention to a fund's risk.
131. Id. at 8, 34 tbl.2. Other factors controlled for were the fund family's size, whether the family already had a fund with the same investment objective, the amount of time the fund had incubated, the fund's risk-adjusted return, and the total amount of flow industry-wide into funds with that investment objective. Id. The incubated fund's risk-adjusted return - unlike the total return - had no statistically significant effect on the decision to open a fund to the public.
132. Id.
133. Garavito, supra note 67, at 17-18.
134. Wisen & Chiang, supra note 56, at 60. Recall that Morningstar relies upon the fund sponsor to notify it regarding the existence of a new fund. Thus, by delaying this notification, a fund sponsor can delay a new fund's inclusion in Morningstar.
135. Id.
136. Wisen and Chiang examined the returns of timely additions in fourteen Morningstar categories (such as large-cap growth) in each of the six months following the funds' inceptions, for a total of eighty-four category-months. In sixteen of these category-months, the timely additions' returns were statistically significantly different from those of similar, seasoned funds. For fifteen of those sixteen category-months the new funds outperformed the seasoned funds; in only one category-month did they underperform the seasoned funds.
137. Id. at 60, 62, 63 exh.6.
138. They examined the returns of retroactive additions in the same fourteen Morningstar categories in each of the six months following the funds' inceptions, again for a total of eighty- four category-months. Id. In only five of these category-months were the retroactive additions' returns statistically significantly different from those of similar, seasoned funds. Id. Also, in only three of these five category-months did the retroactive additions outperform the seasoned funds; in the other two category-months they underperformed the seasoned funds. Id.
139. Koehler & Mercer, supra note 47, at 1110-1113
140. Id. at 1110-1111
141. Id. at 1112-1113
142. Id.
143. Section 34(b)(1) of the Investment Company Act, echoing the language of Section 17 of the Securities Act and Rule 10b-5 of the Securities Exchange Act, states: It shall be unlawful for any person to make any untrue statement of a material fact in any registration statement, application, report, account, record, or other document filed or transmitted pursuant to this title. It shall be unlawful for any person so filing, transmitting, or keeping any such document to omit to state therein any fact necessary in order to prevent the statements made therein, in the light of the circumstances under which they were made, from being materially misleading. Investment Company Act of 1940, 15 U.S.C. § 80a-34(b)(l) (2008).
144. C.F.R. 230.156(b)(2)(i) (2008).
145. Press Release, Securities & Exchange Commission, Van Kampen Investment Advisory Corp. and Former Secior Official Censured and Fined For Disclosure Violations Regarding "Incubator" Growth Fund (Sept. 8, 1999), available at http://www.sec.gov/news/press/pressarchive/1999/99-111.txt. Van Kampen and its former Chief Investment Officer were censured and fined $100, 000 and $25, 000, respectively.
146. Id.
147. Van Kampen Inv. Advisory Corp., Investment Advisors Act of 1940 Release No. 1819, Investment Company Act of 1940 Release No. 23996, 54 S.E.C. 355, 357 (Sept. 8, 1999).
148. Id.
149. Id. at 358.
150. Id.
151. Id.
152. Id. at 359.
153. Id. at 360.
154. Id. at 359.
155. Id. at 358 n.3. The SEC defined "hot IPOs" as "securities that trade at a premium over their initial public offering price immediately after the initial public offering."
156. Id. at 359.
157. Id. at 359 n.4. The SEC produced the 50 percent figure by calculating the fund's actual gains on the IPO shares. We believe, however, that Van Kampen's one-third figure better measures the subsidy that the fund received - if the fund had been forced to buy the IPOs on the secondary market, the fund would not have received an advantage over other investors.
158. Id. at 361.
159. Id.
160. Id. at 361-362
161. Id.
162. Dreyfus Corp., Securities Act of 1933 Release No. 7857, Investment Advisors Act of 1940 Release No. 1870, Investment Company Act of 1940 Release No. 24450, 54 S.E.C. 635 (May 10, 2000).
163. Id. at 636.
164. Id. at 639.
165. Id.
166. Id. at 640.
167. Id. at 641-642
168. Id. at 642.
169. Id.
170. Id. at 641.
171. Id. at 644.
172. Id.
173. Id.
174. Wisen & Chiang, supra note 56, at 60, 61 exh.5.
175. See supra Part II.B.3.b.
176. Van Kampen Inv. Advisory Corp., Investment Advisers Act of 1940 Release No. 1819, Investment Company Act of 1940 Release No. 23996, 54 S.E.C. 355, 361-62 (Sept. 8, 1999).
177. Investment Company Act Release No.16254 (Feb. 2, 1988).
178. Securities and Exchange Comission, Form N-1A, Information Required in a Prospectus: Risk/Return Summary: Investments, Risks, and Performance (2)(c)(2)(ii), available at http://www.sec.gov/about/forms/formn-la.pdf (last visited Sept. 12, 2009).
179. C.F.R. § 230.482(d)(3) (2008) (requiring that any "quotation of the company's performance contained in an advertisement" be limited to "[a]verage annual total return for one, five, and ten year periods, except that if the company's registration statement under the Act (15 U.S.C. 77a et seq.) has been in effect for less than one, five, or ten years, the time period during which the registration statement was in effect is substituted for the period(s) otherwise prescribed").
180. Advertising by Investment Companies, Securities Act Release No.6753 (Feb. 2, 1988).
181. MassMutual Inst., Funds, SEC No-Action Letter, 1995 SEC No-Act. LEXIS 747, at *7 (Sept. 28, 1995).
182. The SIAs were investment vehicles for pension plans qualified under the Internal Revenue Code § 401, and thus exempted from the Investment Company Act's definition of "investment companies." Id. at *1 n.2. Each SIA held a portfolio of securities, which were contributed to a new mutual fund in exchange for shares of the fund. As a result of the transaction, each SLA owned shares of a mutual fund that owned the same portfolio of securities that the SIA had previously owned directly. In addition, MassMutual provided $107, 000 of initial capital to each new fund.
183. Id. at *14.
184. Id. at *1.
185. Id. at *7. These prior returns were adjusted to reflect the deduction of fees and expenses that would have been applicable if the SIA had been a mutual fund.
186. Id. at *4-5.
187. Id. at *4 n.5. They also included the disclosure that "the SIAs were not registered under the 1940 Act and therefore were not subject to certain investment restrictions that are imposed by the Act, " and the disclosure that "if the SIAs had been registered under the 1940 Act, the SIAs' performance may have been adversely affected."
188. Id.
189. Id. at *7. The SEC cited a number of MassMutual representations as evidence that the mutual funds were being managed the same as their predecessor SIAs. MassMutual was the investment adviser for all of the funds and the SIAs. Also, each fund that had sub-advisers had the same sub-advisers as its predecessor SIA. In addition, each fund had management practices, investment policies, investment objectives, guidelines, and restrictions that were "in all material respects" equivalent or identical to those of its predecessor SIA.
190. Id. at *2-3.
191. Id. at *3. The evidence the SEC staff cited for this conclusion was the long length of time between the establishment of the SIAs and their conversion into mutual funds. The SEC noted that "[t]wo of the seven SIAs have existed for more than 20 years, and two others have existed for more than 10 years. Of the other three SIAs, one was established in 1987, one in 1989, and one in 1991."
192. Id.
193. Id. at *6.
194. Id.
195. Id. at *6.
196. Id. at *6 n.8.
197. Stern Sch. of Bus., SEC No-Action Letter, 1997 SEC No-Act. LEXIS 316, at *1 (Feb. 3, 1997).
198. Id. at *3.
199. Id. at*l.
200. Id. at *2.
201. Id. at *2-3.
202. Janus Capital Corp., SEC No-Action Letter, 2000 SEC No-Act. LEXIS 826, at *17 (Aug. 28, 2000).
203. Id. at *2.
204. Id. at *4.
205. Id. at *17.
206. Id. at *14.
207. Id. at *17-18. Janus represented that, when presenting the new funds' performance, it would disclose that each new fund had been previously organized as another fund, the date that each new fund commenced operations, and that the reported information included performance of the predecessor funds.
208. Id. at *5.
209. For example, the SEC warned against a mutual fund that is spun off from a class of another fund presenting performance information but failing "to [also] disclose adequately the performance of the predecessor class (for example, as supplemental, non-standardized performance information in the fund's registration statement, advertisements or sales literature)." Id. at *18 n.19. The SEC stated that such a fund "could be deemed to have omitted to state a fact necessary in order to make the statements in its registration statement, advertisements or sales literature not materially misleading."
210. Id.
211. Id. at *18.
212. Nicholas-Applegate Mut. Funds, SEC No-Action Letter, 1996 SEC No-Act. LEXIS 674, at *7 (Aug. 6, 1996). About a decade earlier, the SEC allowed funds in their first year of operations to include in their prospectuses and advertisements the recent performance of similar private accounts. However, this permission was formally limited to closed-end funds.
213. Growth Stock Outlook Trust, Inc., SEC No-Action Letter, 1986 SEC No-Act. LEXIS 2026, at *10 (Apr.
214. Nicholas-Applegate Mut. Funds, SEC No-Action Letter, 1996 SEC No-Act. LEXIS 674, at *5-6 (Aug. 6, 1996).
215. Bramwell Growth Fund, SEC No-Action Letter, 1996 SEC No-Act. LEXIS 668, at *7 (Aug. 7, 1996).
216. Id. at *5-6.
217. ITT Hartford Mut. Funds, SEC No-Action Letter, 1997 SEC No-Act. LEXIS 259, at *7-8 (Feb. 7, 1997).
218. Id. at*l-2.
219. GE Funds, SEC No-Action Letter, 1997 SEC No-Act. LEXIS 269, at *10 (Feb. 7, 1997).
220. Id. at *14.
221. Wyatt, supra note 82 (giving examples of large fund companies that registered new mutual funds with the SEC but kept them hidden from the general public until the funds had a strong performance record that could be advertised).
222. In a survey of fund companies, most denied ever incubating funds while others admitting doing so or declined to answer. Jason Zweig et al., The Good, The Bad and The Ugly: Which Fund Companies Put Investors First?, MONEY, Feb. 1, 2004, at 74.
223. For a fuller discussion of how such free-riding on educational efforts to correct consumer misperceptions may prevent a seller from making such investments, see Oren Bar-Gill, The Behavioral Economics of Consumer Contracts, 92 MINN. L. REV. 749, 758-61 (2007).
224. See supra Part II.B.3.a.
225. Capon et al., supra note 20, at 77.
226. Id. at 68.
227. Recall that the SEC generally does not allow pre-registration incubation returns to be reported, but has created some exceptions to this policy.
228. See Koehler & Mercer, supra note 47. Recall that in their experiment they provided participants with a fund company's advertisement that highlighted the strong past returns of two of the company's funds. One version of the advertisement stated that the advertised funds were only two of the company's thirty funds. Another version stated that those were the company's only two funds. A third version of the advertisement did not state how many funds the company had. A fourth version (the control) did not mention the funds' past returns at all. Investors were then asked their perception of the quality of the fund company and the likelihood and amount that they would invest in a new fund being introduced by the company. Participants who saw the version that stated the fund company had only two funds and those who saw the version that did not state how many funds existed responded similarly. However, participants who viewed the advertisement disclosing that the fund company had thirty funds rated the fund company's quality lower, were less willing to invest in the company's new fund, and were willing to invest only a smaller amount in the new fund. In fact, they did not respond differently from participants who viewed the control advertisement, which lacked any information about past performance. In other words, they "gave little weight to the excellent (but selected) performance data that they saw in the ad." Koehler & Mercer, supra note 47, at 1113.
229. Two studies reached opposite conclusions regarding whether investors already somewhat discount performance data from fund companies that incubate. Garavito found that funds that were incubated receive less flow than similar-performing funds that were not incubated. Garavito, supra note 67, at 19-20, 34 tbl.8. Evans, however, found that investors don't differentiate between incubated and non-incubated funds with similar past returns. Evans, supra note 53, at 23 & tbl.IV.
230. See supra Part I.B.1.
231. Garavito, supra note 67, at 21.
232. Mark Hulbert, Strategies: Survival of the Fittest? Or Is That Lion a Lamb?, N.Y. TIMES, Jan. 11, 2004, § 3, available at 2004 WLNR 5662248 (Westlaw) (quoting Stephen Oristaglio, Senior Managing Dir., Putnam Invs.).
233. Garavito, supra note 67, at 13-14.
234. See supra Part II.B.2.
235. Further evidence that incubation doesn't help identify good managers is that fund families that incubate have higher fund manager turnover than do fund families that do not incubate. Evans, supra note 53, at 25.
236. Wyatt, supra note 82.