Incubator Bias

Incubator Bias – What We Don't Know That We Don't Know

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Incubator Bias
Incubator Bias
Incubator Bias

In addition to funds that die, there is an indeterminable number of funds that are aborted. These funds are referred to as incubator funds, and are basically experiments within a fund firm that never develop into a publicly available mutual fund.

Upon their inception, the funds are not available to the public; therefore, they are safe from public scrutiny. After a time, the fund shop rolls out only the best performing funds. And some of the best performing funds have unusual reasons for performing so well, like limited access to IPOs. Click here to see an SEC case on this issue.

The stock picking managers of these incubator funds tried something new and ended up with a failure. This little known fact has yet to be quantified in the average returns of stock pickers.

Finally, there are the revolving doors of stockbrokers who are churning through clients and constantly rotating from one firm to another. Their records are quickly extinguished, never to be counted in the average of stock pickers.

This Wharton School dissertation paper explains fund incubation as a "strategy for enhancing return histories . . . the process of running lightly-capitalized, self-funded investment accounts in a semi-private environment." The dissertation in finance for Richard Evans states that the fund returns of funds emerging from incubation was 18% per year above the average return of funds when discarded funds were included. Mr. Evans cited an incubated fund that produced a three-year annualized return of 28.79%, which resulted in a Morningstar "5-Star" rating. About 125 incubator funds have come and gone in a ten-year period. The study concluded that the funds that made it out of the incubator had severe return reversal after the funds were offered to the public. This is indicative of the returns being explained by luck, rather than skill.

Two of the largest fund firms implicated in the recent scandals were among the major participants in this strategy. They started with large numbers of incubation funds in order to, in the paper's words, "upwardly bias investors' estimates of their ability, and thereby attract additional inflows," killing them off when the tough real world of investing brought their returns back down to reality. This is described as "organizing, operating, and managing" funds in the interest of their promoters to the detriment of their investors. Investors would benefit from a restriction of the promotion of the returns earned by these incubated funds during their incubation period.