Insights into how the incubator fund process can let fund managers “bury their losers” can keep investors out of bad mutual funds.

Here’s a remark overheard at a gathering of mutual fund managers. One mutual fund marketer commented offhandedly that, “It might be too early to buy, but it’s a great time to set up a incubator fund or two.” It seemed to me that the comment said more about the mutual fund industry than it did about the market.

An “incubator fund” is a term used to describe a mutual or hedge fund that gets set up mainly to demonstrate the expertise of the fund’s managers. Amateur traders who have had a run of success will often set up an incubator fund, particularly a hedge fund, using their own money. The incubator fund gives them a vehicle they can use to showcase their trading skills to the public.

If good results continue, the operator can accept money from investors and put it in the fund. On the other hand, suppose the fund’s performance starts out weak, as sometimes happens with a new fund manager. If so, the fund can simply shut down and return whatever’s left of the contributions of outside investors. Then the would-be fund manager can simply start over with a new incubator fund.

Mutual funds: Where underperforming funds go to die

The incubator fund strategy works even better for major mutual fund operators, who do it in a bigger way. Rather than starting a single incubator hedge fund, a major fund operator might start a half-dozen incubator funds, each with a different investment strategy.

At the end of a year, results of the six will vary, but one is bound to stand out. It may have gained 20% or even more. (If it turns out to have followed the best possible strategy for profiting in the previous year’s market, it may have gained 50%. But that’s rare.) In contrast, the five underperformers may have gained anywhere from 2% to 8%.

The fund operator may then promote the top performer from its unofficial “incubator” status to a place in the company’s “fund family”, and begin advertising its results to the public, and selling fund units to investors. Rather than keep the five underperformers on life support, it will probably merge them into the one that outperformed.

Of course, the merged fund will go by the results and name of the fund that outperformed. The performance records of the five laggards will get buried along with their names, never to be mentioned again, at least publicly.

This explains why it may seem that every mutual fund you hear about has a record of beating the market. The underperformers often get, shall we say, “put out of their misery.” Or, as mutual fund executives sometimes say, when an incubator fund underperforms, “we take it out back and shoot it.”

Three buying tips for investing in mutual funds

1. Avoid buying mutual funds with a lot of dead weight

When a fund’s portfolio shows page after page of obscure speculative stocks, particularly thinly traded ones or recent new issues, you can be exposed to a concealed, but very serious, risk. If the market drops, and too many investors want their money back, the mutual fund may have to sell some of its assets to raise cash.

Obscure speculative holdings will prove hard, if not impossible, to sell when prices are generally low. This may force the mutual fund manager to dump his best holdings at a time of market weakness. A poor performing incubator fund could be the dead weight in a fund family. It’s best to research each fund very carefully.

2. Beware of buying vaguely described mutual funds

Get rid of mutual funds that show wide disparities between the mutual fund’s portfolio and the investments that the sales literature describes. Many mutual fund operators describe their investing style in vague terms.

It’s often hard to find out much about who is making the decisions, what sort of record they have, and what sort of investing they prefer. We always take a close look at a mutual fund’s performance and investments to see if they differ from what the prospectus or sales literature would lead investors to expect. When the mutual fund takes on a lot more risk than you’d expect, our advice is to get out.

If an incubator fund performed well, it may receive a marketing push from the brokerages sales team. This may cause the disparities you see in the fund’s prospectus and other literature. It’s simply so new that they haven’t updated the informational mailer.

3. Get out of buying “theme” mutual funds

If the mutual fund’s theme seems to be plucked from recent headlines, stay away. It pays to stay out of narrow-focus, faddish funds, all the more so if they’ve come to market when the fad dominates the financial headlines.

Theme funds like these face a double disadvantage, because they appeal to impulsive investors who pour their money in just as the fad hits its peak. This forces the manager to pay top prices—perhaps to bid prices higher than they’d otherwise go—even if this goes against their better judgment. These same investors are also apt to flee when prices hit their lows, forcing the mutual fund manager to sell at the bottom and lowering the mutual fund’s performance. But when a fad dies out, as they all do, the fund’s liquidity dies out with it. The manager may have to dump the mutual fund’s holdings when demand is at its weakest, forcing prices lower than they would otherwise go.

Incubator funds are ripe with themes. In fact, they are a theme mutual fund breeding ground. Once an incubator fund theme is tested and performs well, it may become part of the overall fund family. 

As with all investments, mutual funds require due diligence, including research into the history of the investment. Knowing about incubator funds can also provide investors with insight into the whole mutual fund process.

If you invest in mutual funds, how do you decide which funds to buy? If you used to buy mutual funds but no longer do so, why did you stop? Let us know what you think. Share your experience with us in the comments.

Note: This article was originally published in October 2012 and has been updated.