Incubated Fund

An incubated fund is a fund that is first offered privately in an incubation period. Investors in this type of fund are usually employees associated with the fund and their family members. Hedge funds also commonly use incubated funds to test new strategies and offerings.

An incubated fund may also be called a limited distribution fund.

An incubated fund is usually launched with a specified trial period. In some cases a fund company may test several funds in an incubation trial with the best performing funds advancing. Incubated fund launches are advertised to a select group of individuals and also typically funded with firm capital. These funds generally go through two phases, incubation and public offering.

Incubation is the trial period an investment company uses to test new funds. During the incubation period the incubated fund is only offered to a select group of investors. Investment companies will often test incubated funds with select investors, such as employees and family members. Hedge funds also use a similar approach for incubated funds with the offerings available only to fund employees and family members.

In some cases a fund may choose to test several strategies in an incubation period. If successful, the fund may launch all new strategies or they may plan to launch only the best performing strategy.

Incubated funds can be a prudent way to test a particular fund strategy, specifically if the fund company believes it may have high susceptibility to risks. Using an incubation period allows an investment company to make a small investment in the management and activities of the fund. An incubated fund will closely monitor the trading mechanisms and transaction costs associated with the fund’s activities. Other factors influencing its potential launch to the public will include vehicle structure, registration constraints, demand and potential for success in comparison to other funds in the market or with the fund family. Overall, a small investment made in an incubated fund can far outweigh the costs of launching an unsuccessful fund that requires closing after only a short period of time.

In addition to testing the operational activities of a fund in an incubation trial, the test phase also allows companies to privately gauge the potential public market support it will receive from distributors, intermediaries and service providers. These entities are important to the public launch of registered funds specifically. Distributors partner with the fund to market and list it with discount brokerages and on financial advisor platforms. Additionally, most new funds sign waiver and discount agreements that keep the net expenses lower in the first few years after the public launch. Once a fund company decides to clear a fund for launch, it may also provide additional capital for the fund, which is integrated into its waivers and discount agreements, helping to potentially keep expenses comparatively lower than other fund competitors.

A fund company is generally not required to disclose incubation trials in its registration documents. In some cases, however, fund companies may utilize performance obtained in an incubation trial as hypothetical returns. Critics sometimes find this practice misleading since incubation trial performance may not always fully represent the returns and expenses incurred in the public market. Investors should always be cautious of hypothetical returns and ensure that they fully understand the assumptions associated with them.