What Is Incubation?

Incubation is a trial process in which a fund company operates a single fund or group of funds privately with its own capital or employee capital in order to test the operating characteristics of the fund. Funds tested in incubation are known as incubated funds.

Incubation Explained

Incubation is a common practice used by both mutual fund companies and hedge funds to gauge the demand and operating characteristics of a potential new fund.

Incubation Strategies

Investment companies may use an incubation trial process to test a single fund or a group of funds. The fund company will base its decision to launch a fund on a number of considerations. In the case of multiple funds in incubation, it may only provide funding and resources for one new fund.

Testing funds in incubation allows a company to make a small investment that could save them money in the long term if they find the fund to be unprofitable. Incubation funds are typically open to a company’s employees and family members, with the company often investing seed capital as well.

Incubation Considerations

Launching a fund in incubation allows the company to monitor it in a test phase, watching for numerous characteristics. Top considerations for the fund may include transaction costs and trading complexity. Other factors will include demand from investors, interest from potential distributors and intermediaries, the fund’s total operating costs, and the management team needed to manage the fund comprehensively. In some cases, a company may choose to identify a sub-advisor for the fund if it does not have the necessary expertise internally.

Public Fund Launches

If a company finds that its incubation period proves to be a success for the fund, the next phase will include the preparation and announcement of a public launch. If it is testing a group of funds it may proceed with the best performing fund for launch.

New registered fund launches require a great deal of due diligence and registration documentation. They are also typically accompanied by featured relationships with fund distributors and financial advisor platforms. Many funds will offer lower fees in the first few years following their launch. These fees are the result of waivers and discounts that the company has determined through its incubation or preliminary launch phase. Waivers and discounts can be supported by seed capital from the fund company as well as discounts from service providers.

Disclosure

A company may operate funds in incubation without restrictions. These funds are not required to disclose their status as an incubated fund in registration documents. This leaves incubation trials and incubated funds as private test investments generally known and analyzed only by the fund company.

In some cases, a fund company may report details of the incubation trial period with incubation performance serving as preliminary expectations for a fund. Investors should always be cautious of hypothetical investment performance as it may not take into account the full costs of operating the fund in a public market.