Palmiter & Taha on Manipulation of Mutual Fund Performance

Star Creation: The Manipulation of Mutual Fund Performance through Incubation, by Alan R. Palmiter,  
Wake Forest University - School of Law, and Ahmed E. Taha, Wake Forest University - School of Law, was recently posted on SSRN.  Here is the abstract:

The article argues that some mutual fund companies mislead investors by marketing new funds with artificially high returns. These companies create a number of small, new mutual funds that initially operate out of public view. After a period of incubation, the strong performers are actively marketed to the public while the weak performers are quietly terminated. By highlighting the successful incubator funds and hiding the unsuccessful ones, these companies create the illusion that that the successful funds' returns were the result of skill rather than luck. In addition, some companies subsidize their incubator funds to further artificially boost their performance. When the successful incubator funds are opened to the public, investors flock to them, attracted by the high advertised returns. However, the funds' luck and subsidies soon end, and thus so too do their high returns.

We argue that the SEC must do much more to prevent fund companies from using a manipulated incubation process to mislead investors. We also propose different regulatory approaches to this problem.