Why Do Fund Families Release Underperforming Incubated Mutual Funds?

• Author: Jeffrey R. Stark,Sara E. Shirley
• DOI: http://doi.org/10.1111/fima.12103
• Published date: 01 August 2016
• Date: 01 August 2016

Why Do Fund Families Release

Underperforming Incubated Mutual

Funds?

Sara E. Shirley and Jeffrey R. Stark∗

Although the average incubated mutual fund outperforms nonincubated funds by up to 3.41%

annually,a large number of released funds underperform during incubation. Wefind that launching

underperforming incubated mutual funds is associated with objectives that attract large inflows

and lower relative risk. These findings are consistent with the use of incubation to maximize

fee revenue through means other than the flow-to-performance relationship. We also find that

underperforming incubated funds are incubated longer suggesting that families release funds

opportunistically to take advantage of outperformance when it is observed.

The value of a mutual fund to its fund family is its ability to generate revenue. This revenue

comes from a fund’s capacity to increase its assets under management, which, in turn, increases

the fees collected by the fund and results in additional revenue for the fund family. Evans (2010)

discusses four methods that are used by fund families to increase revenue, one of which is fund

performance.

It is well established in the literature that the mechanism by which performance leads to in-

creased revenue is the relationship betweenpast performance and current period inflows (Ippolito,

1992; Chevalier and Ellison, 1997; Sirri and Tufao,1998). As a fund outperfor ms, investorschase

performance, which increases assets under management and provides additional fee revenues for

the family. However, competing on the basis of performance is a difficult task given the doc-

umented underperformance of mutual funds (Jensen, 1968; Carhart, 1997; French, 2008; Fama

and French, 2010). Nevertheless, outperformance does occur and may be the result of favorable

treatment of a specific fund within a family (Guedj and Papastaikoudi, 2004; Gaspar, Massa, and

Matos, 2006) or incubation (Evans, 2010).

The process of mutual fund incubation begins when fund families internally launch small

funds with low levels of total net assets. After a period of evaluation, the family determines

which mutual funds to publicly launch and which funds to discontinue. By taking advantage

of the incubation process and the established relationship between past performance and current

period inflows, mutual fund families are able to selectivelylaunch incubated mutual funds that, on

Wethank an anonymous referee, Marc Lipson (Editor), Scott Gilbert, Jason Greene, James Musumeci, Edward Nowlin,

Mark Peterson, David Rakowski,and Wanli Zhao for helpful comments and discussions. We are also thankful to Frank

Hatheway fromNASDAQ for providingthe data on mutual fund ticker creation dates and to seminar participants at Roger

Williams University.The authors are responsible for any remaining errors.

∗Sara E. Shirley is an Assistant Professorof Finance at Roger Williams University in Bristol, RI. Jeffrey R. Stark is an

Assistant Professor of Financeat Bridgewater State University in Bridgewater, MA.

Financial Management •Fall 2016 •pages 507 – 528

508 Financial Management rFall 2016

average, have generated a positive objective alpha. However, outperformance is difficult to come

by.Evans (2010) suggests that incubation is not used to identify skilled managers, but to generate

a misleading track record of outperformance as the Securities and Exchange Commission (SEC)

allows incubation period performance to be advertised once a fund has been released, but does

not require that the performance of discontinued funds be documented.

The process of mutual fund incubation raises two unanswered questions: 1) what factors de-

termine how long a mutual fund is incubated? and 2) why do a large portion of incubated

funds that are released to the public underperform during the incubation process? These ques-

tions are the focus of the present study. We examine a sample of 3,610 US domestic equity

mutual funds from 1999 through September 2014 and find that 22.63% (817) of the funds are

incubated.

We determine that of the 817 incubated funds in our sample, 354 or 43.33% have negative

incubation period performance when measured by an equallyweighted objective alpha. Our results

indicate that the release of underperforming funds is significantly related to an objective that is

attracting large inflows. This finding helps explain the launch of underperforming incubated

funds and suggests that the need to fill family demands may be a major driving force in how

mutual fund families use incubation.

We also find that the probability of a quicker release of a fund is positively associated with

incubation period performance, objective inflows, and family inflows.These f indings support the

view that fund families take advantage of outperforming incubated mutual funds as they appear

in order to avoid any spuriously outperforming mutual funds from reverting back to average

performance. In addition, these results support fund families launching incubated mutual funds

faster when there is increased demand for the fund family’s mutual funds or the incubated mutual

fund’s objective, suggesting that fund families seek to take advantage of spillovereffects (Nanda,

Wang, and Zheng, 2004).

This paper is organized as follows. Section I details the data, while Section II examines

the distribution of incubation period performance and its relationship with flows. Section III

provides the empirical analysis of incubation length. Section IV presents the empirical analy-

sis of the decision to release an underperforming mutual fund, while Section V provides our

conclusions.

I. Data and Sample Creation

Incubated mutual funds are identified based on information from two databases. Mutual fund

data (excluding ticker creation dates) are obtained from the Survivor-Bias-Free US Mutual Fund

Database hosted by the Center for Research in Security Prices (CRSP). Other variables of interest

from the CRSP database include mutual fund and fund family characteristics.1Ticker creation

dates, or the date when a mutual fund is made availableto the public, are obtained from a database

hosted by the National Association of Securities Dealers (NASD). The NASD database provides

a snapshot of all active mutual funds for each month from January 1999 to September 2014 and

includes data for the ticker creation date, the fund’s ticker, and the fund’s name. Variables from

1CRSP Style codes were utilized to create our sample of domestic equity mutual funds. Codes of EDSG, EDSH, EDSF,

EDSN, EDSR, EDST,EDSU, EDSG, EDSS, EDSI, EDSM, EDSA, EDS, EDCL, EDCM, EDCS, EDCI, EDYG, EDYB,

EDYH, EDYS, and EDYI were retained. For a complete description of the objectives used, see the Appendix (Section I

and TableA1).