The poor performance of hedge funds that have converted to mutual funds has prompted Morningstar to cease publishing historical performance data prior to the funds’ conversion.

The change is set to take effect in the third quarter.

Jeffrey Ptak, global director of manager research at Morningstar, said the change in policy is due to chronically bad performance that hedge funds have turned in after they’ve converted to liquid ’40 Act funds.

“Many of these converted funds have been dismal performers,” he said in a report this month.

An SEC rule allows hedge funds to report the historical performance, but hedge funds are typically unregistered and don't publicly disclose holdings or performance, Ptak says in the report.

That “leaves the door wide open for firms to convert hedge funds with records that have been cherry-picked or data-mined,” he said.

Ptak and John Rekenthaler, Morningstar vice president of research, also suspect that formerly successful hedge funds have seen their performance revert to the mean after converting.

Morningstar includes the pre-conversion numbers in its performance data, although pre-conversion data is not used in star ratings.

Twenty-four mutual funds will be affected by the new policy. Another 10 converted funds have since closed due to poor results, Morningstar says.

As a group, these former hedge funds hold about $7.8 billion in assets. Four funds account for the bulk of assets—Catalyst Hedged Futures ($2.5 billion), Catalyst/Millburn Hedge Strategy ($2.4 billion), Pimco EqS Long/Short ($548 million) and Vivaldi Merger Arbitrage ($504 million).

Of the 34 hedge funds that have gone open-end, 23 beat their prospectus benchmark prior to converting, Ptak said in the report. The average excess return of these winning funds “was a startling 7.9 percent per year” above their benchmark, he said.

But once converted to a public fund, only eight of the 23 beat their benchmark (seven of the eight were benchmarked to cash or bonds). The 15 funds that lagged their benchmark did so by nearly 10 percent per year on average, Ptak said.

Overall, the average hedge fund beat its benchmark by about four percentage points per year before converting and trailed its index by more than six percentage points per year once it converted into a mutual fund.

Ptak doesn’t think the change will reduce the number of hedge fund conversions, though, because pre-conversion data was never used in star ratings.

“Firms that opted to convert … weren't doing so because they wanted to come out of the gate with a high star rating,” he said in an email.

The poor showing for most converted hedge funds is a reminder to dig deeper before chasing returns, Ptak added.

“Some of these less-than-successful hedge fund conversions vividly illustrate that concept,” he said.