When an investment company or a hedge fund launches an incubated fund, its primary intention is to test its strategies. Hence, it is offered to a limited number of investors in its incubation phase. The feedback from such investors helps a company fine-tune its product before it is offered to the public at large.
What is an Incubated Fund?
Funds that are privately offered to certain investors during their incubation period are known as incubated funds. Typically, an incubated fund is offered to a fund’s employees and their family members. Such funds are often used by hedge funds to test their new products. By testing these products, hedge funds can experiment with new strategies to see how they perform.
Only a limited number of investors are invited to invest in an incubated fund. Hence, such funds are also known as limited distribution funds.
How Do Incubated Funds Work?
When an incubated fund is launched, it usually has a certain trial period. At times, a hedge fund can even test many funds during the trial period and let only the well performing funds advance.
Incubated funds mostly go through two important phases in their journey. The first phase is called “incubation” and the second phase is known as “public offering.”
In the incubation phase, a company tests new funds by offering them to select investors, like its own employees or their family members. At times, a company may test many strategies in this phase. If all the strategies are successful, the company may launch all of them. If not, it may launch only successful strategies.
Incubated funds allow an investment company to analyse strategies, which have the potential to be risky. In the incubation period, a company makes a small investment in managing an incubation fund. This small investment can outweigh the cost of launching an unsuccessful fund that may even need to be closed after some time. Hence, incubated funds are extremely important.
Apart from testing a fund’s operational activities, the incubation phase also allows a company to assess the support it will get from intermediaries like distributors and service providers.
Benefits of Incubated Funds
The main benefits of incubated funds are explained in detail below:
Help test new strategies: Investment companies often use incubated funds to test new strategies, which help them assess whether new products will be viable or not before they are offered to a broader set of investors.
Risk mitigation: As incubated funds are offered to a limited number of investors, they help their promoters in risk mitigation. With the help of incubated funds, investment companies can reduce the potential risk of a product before launching it for a wider set of clients.
Gauge the response of intermediaries: Incubated funds also help an investment company analyse the potential support it will get from intermediaries like distributors upon launching a product. Support from intermediaries is extremely important because these parties ultimately take a product to investors.
Improved flexibility: By launching an incubated fund for a limited set of investors, an investment company has the flexibility to tweak the fund based on the feedback it receives from investors, which helps in fine-tuning the fund for the long term.
Incubated Funds in Hedge Fund Strategies
Incubated funds are extremely important for hedge funds to develop their strategies. Such funds help hedge funds test new strategies or products in a controlled environment before offering them to investors at large.
Hence, in the incubation phase, hedge funds offer such funds to a limited number of investors, who are often their employees and their families. When a product is launched for a few investors in the testing phase, it helps a hedge fund manager understand how it will perform under different market conditions, which eventually allows them to fine-tune their strategies.
The main benefit of incubated funds is that they help hedge fund managers mitigate risk, as such funds are launched only for a select number of investors. Hence, the managers do not have the pressure from a large number of investors.
To investors, such funds provide exclusive opportunities to invest in an idea, which is in the development stage. If an incubated fund does well, early investors might earn high returns when it is launched for the broader market.
Risks and Considerations of Incubated Funds
If you are thinking of investing in an incubated fund, then you should be mindful of the risks associated with such products, which are explained below:
Market risk: An investment in an incubated fund exposes you to market risk, as the market can witness massive fluctuations in a short period of time, which can badly affect the value of your investments. Hence, when you invest in incubated funds, you should be willing to face market volatility, uncertainty, and fluctuations.
Manager risk: The returns of an incubated fund depend upon the skill and experience of its manager. Hence, before investing in such funds, you should thoroughly research the past performance of their managers. You should also bear in mind that the incubation period of a fund can last a long time. Hence, you can be exposed to manager risk for a considerable length of time. So, you must avoid investing in funds led by subpar or inexperienced managers. That said, even highly skilful and experienced managers may not be able to deliver high returns. Hence, there is always an element of manager risk in such funds.
How to Participate in an Incubated Fund?
If you want to participate in an incubated fund, here is the roadmap you should follow:
Understand the fund type: First, you need to understand the product. You should ask questions like, “What kind of an incubated fund is it,?” “What kind of securities does it invest in,” and “What is the investment philosophy of its manager?” Only if you have answers to such questions will you be able to decide whether to participate in the fund or not.
Check its eligibility: Incubated funds are typically offered to a limited number of investors. They are usually the employees of an investment company that has launched the fund or they tend to be the family members of those employees. Hence, you need to check eligibility to determine whether you are permitted to invest in the fund.
Get an invitation to invest in a fund: In most cases, you need an invitation to invest in an incubated fund. To get an invitation, you need to be an employee of the company that has floated a fund or a family member of an employee.
Adhere to the specific requirements of a fund: After you get an invitation, you need to follow the specific requirements to invest in a fund, which could pertain to minimum investment thresholds, etc. You should read all the necessary documents to make such an investment.
