What it means
Investors tend to choose funds that already have a track record, which creates a problem for new funds with no history. To get around this, the firm starts several small funds quietly, funded by the firm itself, and gives each a different strategy or manager.
After a year or two, the firm compares the results. The funds that performed well are opened to the public with their history attached, while the weaker ones are closed or merged and quietly disappear from the record.
This is where the difficulty lies, because the track record shown to investors comes from funds picked precisely because they did well. This is known as incubation bias or survivorship bias, and it means the early returns tend to flatter what the fund can be expected to deliver afterwards.
Incubation also has legitimate uses. It allows a manager to test a strategy with real trades, iron out operational problems and prove the process before taking on outside money.
Regulators generally expect firms that advertise incubated performance to be open about how it was achieved. For an investor, the sensible response is to ask whether the fund was incubated, how many sister funds were started and closed, and how the fund performed after it opened to the public.
Returns after launch are a more reliable guide than the incubation-period figures. Some firms also run incubated funds to build a record for a particular share class or a new team of managers.
In those cases the useful questions are who ran the money during incubation, whether the same people still run it, and whether the fees charged to outside investors will be higher than the pilot ever bore. A pilot with no fees looks better than a live fund that charges them.
In practice
Real-world examples.
Example
An asset manager has a new idea for a fund investing in small companies. It puts $5,000,000 of its own capital into the strategy for 18 months, and when the results look strong it launches the fund to investors.
Example
A pension consultant reviewing a young equity fund notices that the first two years of returns are very high and then fall back. She asks the manager whether the fund was incubated and finds that the early returns came from a private pilot.
Example
A fintech asset management start-up runs five small automated trading strategies using staff money. Only the two with the best results are packaged into funds for clients, and the other three are shut down.
Formula
Calculation
Incubation bias = Average return of surviving funds - Average return of all funds started
A firm starts 10 incubated funds. Four of them earn an average of 12% over the incubation period and are opened to the public. The other six earn an average of 2% and are closed. The average return across all ten is (4 x 12% + 6 x 2%) / 10 = (48% + 12%) / 10 = 6%. A prospectus showing only the four surviving funds suggests 12%, so the bias is 12% - 6% = 6 percentage points.Case study
Seen in the real world.
Redwood Asset Partners is an illustrative, fictional manager that incubated eight bond funds with $1,000,000 of its own capital each. After two years, three funds had returned between 9% and 11%, while the other five had returned between 1% and 3%.
The three leading funds were launched with glossy brochures showing their incubation returns, and money flowed in. Over the following year, though, the new public funds returned an average of 4%, close to the typical result of the eight.
An analyst at a fictional pension fund noticed the gap and asked for the full list of incubated funds. The illustrative lesson is that early performance chosen after the fact is a weaker signal than it looks, and that fund selectors should insist on seeing the whole group.
Watch out
Common mistakes.
- Treating the incubation-period return as proof of skill, when it comes from a group selected because it did well.
- Assuming incubation is a sign of poor practice, when many reputable managers use it to test strategies and processes responsibly.
- Ignoring the capital behind the track record, since a pilot run with a small amount of money may not scale to a large fund.
Questions
People also ask.
Why do fund managers incubate funds?
They want a performance record and proof of process before asking outside investors to commit money to an unproven strategy.
How can an investor spot an incubated fund?
Look in the fund documents for a launch date earlier than the date it opened to the public, or ask the manager directly about the history of the fund and any sister funds.
Is an incubated fund riskier than other funds?
Not necessarily, but its early track record is likely to be less representative, so the investor should rely more on what happens after public launch.
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