DEFINITION of 'Incubation'

A trial process in which a fund company operates a number of funds privately with its own capital or employee capital, and only opens the top performing funds to the public. The higher performing funds that survive the incubation period are used by the fund company to generate business. The funds with unattractive performance, which would be more difficult to market, are liquidated.

See also "incubated fund."

BREAKING DOWN 'Incubation'

While there is nothing illegal about this practice, some consider it to be unethical because it can overstate the investing performance of the fund company, creating what is known as incubation bias.

For example, suppose that a fund company starts three funds that earn returns of -5%, 2%, and 20%, respectively, over a one-year period. If the fund company only opens the 20% fund to the public and does not disclose the other performances, a bias is created because the average performance of the three funds is actually 5.7%.

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