IS THAT NEW FUND A HARD-BOILED SURVIVOR--OR HUMPTY DUMPTY?
By JASON ZWEIG REPORTER ASSOCIATE: PAT REGNIER

(MONEY Magazine) – As you've just read, new funds can be a great way to add pop to your portfolio. But the performance records of new funds can be misleading, and they can get you into trouble if you don't watch out. That's why I think it's so important for you to learn about how mutual funds can be "incubated."

Right now, incubation is one of the hottest topics in the fund business. And it comes in two basic forms: lots of prenatal care for embryonic funds, and the growing ease with which portfolio managers can start up a brand-new fund and suggest that it has a long track record.

Prenatal pampering. In the fund version of natural childbirth, an investment firm gets a new idea, puts a portfolio manager in charge, and opens it to the public from Day One. An incubated fund, however, is conceived and nurtured in a laboratory: Instead of opening the portfolio to public investors right away, the fund company runs it privately under carefully controlled conditions for a year or more.

Typically, only employees or directors of the money-management firm are allowed to buy in, limiting the size of the fund to a few million dollars. With such a tiny portfolio, the manager can buy smaller stocks and trade more rapidly than he could at a bigger, older fund. And by keeping the baby fund out of the public eye, incubation shelters it from the waves of money that can flood in and out and disrupt the portfolio manager's investment strategy. Finally, incubation can lower expenses (thereby increasing returns) since the fund incurs no marketing costs to bring in outside shareholders.

There isn't necessarily anything sinister about this. "We don't create these funds to juice performance or to hype a record," says John Reilly, a spokesman at the MFS funds, where eight portfolios are being incubated. "We look at this as a laboratory to train promising new managers and try new ideas."

Fair enough. But if you suspect that these laboratory conditions can give incubated funds an artificially big--and perhaps unsustainable--start in life, you're eggsactly right. Look at Van Kampen American Capital Growth, a fund that was fertilized in vitro back in December 1995. In 1996, while still in the hatchery, this fund roared past the 23% return of the S&P 500 with a 62% performance. It opened to the public in February 1997 (and closed in March after attracting almost $100 million). So far this year, the fund is still beating the market, but its waning advantage--35% vs. 31% for the index--suggests to me that much of its sizzle in 1996 came from being incubated. Van Kampen declined to comment.

Another problem with incubation: Most companies will show you only the funds that hatch successfully. The rotten eggs get quietly dumped--creating the misleading impression that all of the fund company's new ideas are good ones.

To see what I mean, look at Putnam, one of the most aggressive incubators in the business. In recent years, Putnam has rolled out several funds--Growth Opportunities, New Opportunities, New Value--which produced market-beating records in incubation. But what about the eggs that didn't hatch? Hold a candle up to Putnam Research Analysts Fund, for instance. Conceived in November 1992, and kept on life support in Putnam's laboratory until February 1995, this fund returned an average of 7.96% annually vs. the S&P 500's 9.23%. No surprise that Putnam let this one go splat. (Two other examples of recent rotten eggs: Putnam Equity Fund 97 and Putnam Real Estate Opportunities.) Putnam has five funds in incubation now, but the firm refuses to disclose their names, their strategies or anything else about them. However, MONEY has learned the names of four of Putnam's secret babies: Global Growth & Income, International, Japan and Research. If the past is any guide, Putnam will see which of these funds can thrive in the cozy warmth of incubation--and then offer you those winners while hiding the ones that didn't grow. Thus incubation makes Putnam and other firms with fund hatcheries look a little better at launching new funds than they really are. Putnam defends the practice of incubation in much the same terms as MFS does. "We believe it's better to road-test funds before putting them in the hands of shareholders," says Putnam spokesman Matt Keenan.

Now let's consider the second kind of incubation: Portable performance records. Elizabeth Bramwell, who managed the Gabelli Growth Fund for seven years, asked the Securities and Exchange Commission last year to let her include her performance at that fund in the prospectus of her new Bramwell Growth Fund. She was able to prove that she had full control over investment decisions at Gabelli Growth, so the SEC granted her request. Though Bramwell's brand-new money-management firm had a limited track record, she was allowed to promote it by citing her performance for her previous employer.

When I first heard about the SEC's Bramwell decision last year, I thought it was one of the dumbest ideas since New Coke. It was obvious to me that it would make already itchy fund managers even more eager to sell their services to the highest bidder. After all, if a fund's track record belongs to both the portfolio manager and his former firm, then any fund company seeking to show a "history" of great performance can simply buy it by hiring away a veteran manager from another company.

In 1995, for example, John Wallace left Oppenheimer Main Street Income & Growth to start up Robertson Stephens Growth & Income, whose new prospectus showed his record at the old fund. And, even as you read this, Thomas Marsico, former star manager of Janus Twenty and Janus Growth & Income, is launching the Marsico Focus and Marsico Growth & Income funds, whose pending prospectus displays his record at Janus. Meanwhile, Oppenheimer and Janus continue to include the former managers' records in their prospectuses too.

The heart of the matter: It's often difficult to apportion credit or blame for a fund's performance between its manager and the fund company. Peter Lynch, the superstar manager of Fidelity Magellan from 1977 to 1990, probably would have earned high returns anywhere--but it didn't hurt that he had a phalanx of Fidelity's brightest young research analysts helping him pick stocks. In fact, Lynch credits dozens of colleagues, and the company as a whole, for much of his success.

Barry Barbash, top fund regulator at the SEC, sees it this way: "There are some fund managers who can set up their own shop and replicate everything they did before at a larger firm. Can information about their prior performance be useful to investors? I think the answer is yes. Can it be used in a way that is not misleading? Yes. But going down this road does raise a lot of difficult scenarios." For example, say a fund is run by a team of managers and one quits to start up his own firm. If he can prove he was the leader of the team, should he be able to publicize "his" prior record? The SEC says it will continue to look carefully at each request.

On balance, I think investors should have access to as much information as possible to help them choose funds. And that's why I'm no longer sure that the SEC's Bramwell decision was so stupid. It's hard to see how talented investors like Marsico and Bramwell could attract shareholders if they were banned from any mention of their past records--and, to its credit, the SEC has insisted that their prospectuses must clearly state that the historical performance of their former funds "is not indicative of the potential performance" of their new ones. However, the new portability of performance means that analyzing a fund's returns--never an easy task--is harder than ever.

Here's how you can cope with confusion in the fund nursery: Be skeptical. If a money manager announces a new fund with an old record, ask whether the "inception" date and the date it was first marketed to the public are different. If so, this baby was incubated--and now that it's out of the lab and fending for itself in the real world, its future results are likely to be a lot lower.

Buy the fund, not just the manager. With hot stock pickers jumping from one fund team to another faster than professional athletes change uniforms, try not to chase them. You should buy a fund not just because you think the manager is smart but because you like the fund's overall strategy, depth of expertise and low expenses. Those should persist even if the manager goes elsewhere.

Look for inside ownership. If fund-manager stability means a lot to you, buy a fund where the owner is also a customer. As I wrote in October, some fund managers who have huge stakes in their own portfolios have a big incentive to stay right where they are so they can keep a close watch on their own money. Some fund companies whose managers have a lot on the line: Davis/Selected, Longleaf and Tweedy Browne.

If you do consider buying a start-up fund from a manager with a good record at another firm, take the warnings in the prospectus seriously. For example, although Tom Marsico is undeniably a very skilled manager, you can't just assume his performance at Janus can be cloned at his new firm. At Janus, Marsico managed investments, not a corporation; now, as the head of his own company, he has to do both. At Janus, Marsico had several dozen analysts to help him research stocks; now he has two. At Janus, Marsico could count on steady cash from 401(k) plans to give him buying power in a market downturn; so far, his new firm can't.

Even if a manager's track record is fully "portable" under the law, it may not be so portable in reality. But if you give a new fund the same skeptical scrutiny you would give to an old one, you'll avoid getting egg on your face.

Reporter associate: Pat Regnier