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Star Creation: The Incubation of Mutual Funds

50 Pages Posted: 19 Mar 2009 Last revised: 16 Dec 2009

Alan R. Palmiter

Wake Forest University - School of Law

Ahmed E. Taha

Pepperdine University - School of Law

Date Written: October 31, 2009

Abstract

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 incubated funds in ways that do not continue after the funds are sold to the public. As a result, the high returns of successful incubated 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.

Keywords: mutual fund, SEC, securities regulation, disclosure, investment, investment company, incubation

JEL Classification: G18, G23, G28, G29, K20, K22

Suggested Citation

Palmiter, Alan R. and Taha, Ahmed E., Star Creation: The Incubation of Mutual Funds (October 31, 2009). Vanderbilt Law Review, Vol. 62, p. 1485. Available at SSRN: https://ssrn.com/abstract=1364087

Alan R. Palmiter

Wake Forest University - School of Law ( email )

P.O. Box 7206
Winston-Salem, NC 27109
United States
336-758-5711 (Phone)
336-758-4496 (Fax)

Ahmed E. Taha (Contact Author)

Pepperdine University - School of Law ( email )

24255 Pacific Coast Highway
Malibu, CA 90263
United States

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