Below is a summary of a paper written in the Journal of Finance regarding incubator funds. Everything I know about them is bad (and this particular paper reinforces it), but I usually get my information for biased sources on this stuff. So those that work in/close to the mutual fund industry - are there good reasons for incubator funds? What purpose do they serve? Mutual Fund Incubation (Digest Summary) Richard B. Evans Journal of Finance, Vol. 65, No. 4 (August 2010): 1581-1611 Summarized by Lee M. Dunham, CFA CFA Digest November 2010, Vol. 40, No. 4: 12–14 (doi: 10.2469/dig.v40.n4.22) View Table of Contents Abstract Abstract Summary Summary Abstract The author examines the impact of mutual fund incubation on fund return performance and fund flows. Results indicate that incubated funds outperform nonincubated funds; the outperformance disappears, however, when the incubation period is over. Also, fund flows to incubated funds are higher than fund flows to nonincubated funds. Many studies have shown that investors chase performance when selecting mutual funds, which creates a strong positive relationship between fund flows and past fund performance. One strategy that mutual funds use to increase the probability of outperformance is incubation. The author examines the role of mutual fund incubation and its impact on fund performance, fund flows, and fund initiation. He finds that incubation leads to higher return performance and fund flows relative to nonincubated funds and that fund families are more likely to incubate funds when their current offerings are having trouble attracting new money. The process of incubation involves a fund family starting a small group of mutual funds internally. These funds are registered as public funds but are not marketed and thus have no ticker symbol, effectively making them private funds. As these funds develop performance records, the fund family decides which funds to continue and market to the public and which funds to terminate. For the funds that survive, the fund family applies for ticker symbols and begins marketing the funds using their strong performance record created during the incubation period. The author gathers monthly return data on new U.S. domestic equity funds created during January 1996 to December 2005 from the CRSP mutual fund database. Data on ticker creation dates for these funds are taken from NASD (National Association of Securities Dealers). These funds are then classified as incubated or nonincubated funds. A fund is classified as incubated if the ticker creation date is 12 months or more after the date of the first reported monthly return for the fund. The ticker creation date is also used to separate performance of incubated funds into performance during the incubation period and performance after the incubation period. During the sample period, 23.1 percent of the new funds were incubated; 66 percent of the funds had an incubation period of 6 months or less, and 10 percent of the funds had an incubation period of 25 months or more. The results of the author’s study indicate that incubated funds statistically outperform nonincubated funds by 9.84 percent annually on a total return basis and by 3.5 percent annually on a risk-adjusted basis using the four-factor model (Fama–French three-factor model plus Carhart momentum factor). Interestingly, the outperformance of incubated funds over nonincubated funds disappears once the incubation period ends. For the three years after the incubation period ends, incubated funds statistically underperform nonincubated funds by 3.17 percent annually on a total return basis. The difference in four-factor alphas for the post-incubation period, however, is not statistically significant. Two potential explanations for the higher performance of incubated funds are that incubated funds use superior investment strategies or that they have superior managers. The author suggests that if these explanations were valid, then the outperformance of incubated funds would not drop off once the incubation period ends or the average tenure of managers of incubated funds would exceed that of managers of nonincubated funds. The average tenure for managers of incubated funds, however, is actually shorter than the average tenure for managers of nonincubated funds. The author finds that incubated funds do have higher fund flows than nonincubated funds, but after he controls for relevant fund factors (fund performance, investment objective, concurrent fund flows, and past fund flows), this difference disappears. The author interprets this result as evidence that incubation is an effective strategy to increase assets under management because investors appear to respond to incubation period performance and do not seem to differentiate between incubation and nonincubation performance when selecting mutual funds. Next, the author investigates the determinants that might lead a fund family to apply the incubation strategy. Regression results indicate that fund families are more likely to incubate funds when their current offerings are having trouble attracting investment dollars and that incubation is more likely for families of funds that are mostly sold through brokers. Again, the author interprets these findings as evidence that fund families utilize incubation in an attempt to enhance performance and increase fund flows. Lastly, the author addresses the upward bias in reported mutual fund returns created by incubation. He shows that the common size filter (using total net assets as a proxy) used by researchers to eliminate the incubation bias does not work and actually creates an additional bias on returns. He proposes two new filters to mitigate the incubation bias: a ticker creation date filter and an age filter. The author demonstrates that application of either of these filters eliminates the incubation bias in returns.
I saw that in the CFA digest too and thought it looked interesting. I know of one fund that I have been speaking to that does this sort of thing regularly. At first glance I can see no justification for incubation related to protecting investor interests. On the other hand, no one is going to buy into a fund without at least a 3 year track record so how else would you get a performance history other than doing something like incubation? I wonder if GIPS has anything to say about it. I guess it might be covered in all of those composite requirements.
I’m not sure if this is covered by GIPS. What you want is some sort of disclosure stating that this fund was one of a number of funds trialled by the fund manager during the incubation period and how many were eventually marketed and what the respective returns of the funds were. That way it becomes clearer if the fund manager has taken a scatter gun approach to several strategies and cherry picking the one that has happened to work recently to market to investors.
Dwight Wrote: ------------------------------------------------------- > I saw that in the CFA digest too and thought it > looked interesting. I know of one fund that I > have been speaking to that does this sort of thing > regularly. > > At first glance I can see no justification for > incubation related to protecting investor > interests. > > On the other hand, no one is going to buy into a > fund without at least a 3 year track record so how > else would you get a performance history other > than doing something like incubation? > That makes sense. I guess my problem lies with launching 7 small cap value funds into incubation and picking different stock in each and then taking the winner live. This is what I have always heard about, but I wasn’t sure if it was true. > I wonder if GIPS has anything to say about it. I > guess it might be covered in all of those > composite requirements. I can’t remember this either.