In the 2007 bestseller The black swan
, author Nassim Taleb predicts the financial crisis, warning of the fragility of the banking system and suggesting that participants require more ‘skin in the game’ to prevent moral hazard.
Many investment directors and fund managers agree that having skin in the game – or a personal investment in an organisation or undertaking – improves the performance of the companies and funds that they direct or manage. It portrays fund managers as having the utmost faith in their talents – if it is good enough for them, then surely it is good enough for you. The February 2017 Skin in the game – just the facts
report from stockbroker Canaccord Genuity, which analyses 279 firms, shows that the total investment in funds by boards and managers has seen a huge increase, from £687m in 2012 to £1.73bn currently.
“A fund management company should align their interests with those of their investors. Indeed, where the asset management sector has fallen into disrepute, it has been on claims that it is self-serving and out of touch with its clients. An insistence that fund managers ‘eat their own cooking’ is a very strong counter argument to those claims,” says Alistair Reid, CEO of CRUX Asset Management. At CRUX, all employees are shareholders, and they are required to invest 25% of dividends from CRUX shares in the firm’s funds for a minimum of three years. “It also helps colleagues, whether in sales, compliance or operations, to remember and understand the primary reason for the existence of our business and why the funds exist.”
Equity investors, too, like to see chief executives having significant shareholdings in their companies. Any share sales are usually a warning sign of impending problems. “Executive remuneration packages will often reward with shares or share options,” says Danny Cox CFPTM
Chartered MCSI of Hargreaves Lansdown. “This helps to align interests of shareholders with company executives.”
But having skin in the game may, in fact, be a far from perfect indicator. There are others who argue that there are downsides to having personal interests tied to a fund. When individual fortunes hang in the balance, excessive risk-taking or cautiousness may then prevail.
“A manager may become overly cautious as they grow older or richer, or if their lifestyle changes, and seek to aggressively protect or punt capital in a way that has deviated from their ‘value-add’ that bore them their wealth in the first place,” suggests Rory McPherson ACSI, head of investment strategy at Psigma Investment Management. “Skin in the game can be a good thing, but any view needs to be taken on a case-by-case basis.”
Lessons from America
In the US, the Securities and Exchange Commission
requires managers of mutual funds to disclose how much they invest in their own funds through a Statement of Additional Information. However, these are submitted in bands – none; $1–$10,000; $10,001–$50,000; $50,001–$100,000; $100,001–$500,000; $500,001–$1m; and over $1m – rather than specific figures.
A 2015 study by Morningstar, the Chicago-based mutual fund research group, finds that US managers investing more than $1m in their own funds have a higher success rate than those that invest less, or nothing at all. In Morningstar’s FundInvestor
, director of fund research Russel Kinnel reveals that managers investing no money in their funds experienced a 35% success rate, and those investing between $100,001 and $500,000 had a 43% success rate. Meanwhile, those who had invested more than $1m had a 47% success rate. The risk-adjusted picture is similar, with a success rate of 28% for managers with no investment, compared with 39% for those who had invested $1m or more.
According to Kinnel, there are a number of factors at play in relation to manager investment and success rates. As managers possess unrivalled knowledge about their funds, they have the ability to evaluate it well based on their own needs. They are also “savvy investors” when it comes to fees, which means that they are more likely to purchase low-cost funds. Furthermore, a fund manager with interests aligned with those of the investors is more likely to invest in a meaningful way, and more likely to identify strongly with the strategy in place. Finally, Kinnel suggests that manager investment can also be an effect of success, with prosperous fund managers likely to be paid more, and therefore investing more in their funds. “To the degree those managers continue to succeed, the investment level will have predictive power. In fact, we’re seeing more bonuses paid in fund shares, which furthers this effect,” says Kinnel.
Opacity in the UK sector – where there is no obligation for managers of open-ended funds to disclose how much they invest – prevents any meaningful gathering of data. However, Terry Smith, founder of UK-based equity fund Fundsmith, has been widely reported as saying that the disclosure of manager holdings in open-ended funds should be mandatory. Smith has invested around £200m of his own money into his flagship Fundsmith Equity Fund, and the popular product now has a fund size of £11.8bn since its inception in November 2011, according to figures from Morningstar. Between September 2012 and August 2017, cumulative returns were 172%.
Sending a message to investors
Closed-end funds, meanwhile, operate under slightly different rules. Because they are traded on exchanges and obey rules that make them more transparent, they must reveal the personal investments of directors and board members.
Canaccord Genuity’s Skin in the game – just the facts
report finds that 90% of chairmen and directors involved in investment companies dealing with closed-ended funds now invest their own money in them, up from 86% in 2012. When it comes to having personal investments worth more than £1m in their own investment companies, 61 chairmen and directors, and 55 management teams, have ‘skin in the game’.
Chief among these is Lord Jacob Rothschild – the highest paid chairman of the firms analysed by Canaccord Genuity, with a total remuneration worth over £2m per annum – and his daughter Hannah, who own a £331m stake in their family trust RIT Capital Partners. As of July 2017
, the fund boasted net assets of approximately £2.8bn. Tetragon Financial Group’s Reade Griffith, Paddy Dear and the broader management team hold the second largest stake in an investment trust, at over £173m.
Advantages and disadvantages of fund managers investing in their own fund
- An endorsement of the fund.
- Greater transparency.
- Empirical evidence from the US that these funds surpass their peers and outperformance increases with the amount invested.
- Alignment of interests between fund manager and shareholders.
- Fund manager has more incentive, taking greater care over decisions.
- Sense of urgency and commitment to performance.
- Good marketing.
- Can lead to improper trading.
- Attitude to risk is very different when you are close to a portfolio. For instance, a fund manager could take on too much short-term risk if a fund is underperforming.
CRUX Asset Management says that delivering the best possible returns to investors, within the framework of risk and clearly stated investment principles, can only be achieved through truly active management, where the fund manager is fully engaged in stock selection and asset allocation. “Good active fund management over the medium- to long-term will always outperform passive funds,” says Alistair. “The phrase ‘hold your feet to the fire’ sums up the correlation between alignment and investment performance. We think it keeps managers far more focused when it is personal, and we believe it is no coincidence that some of the best investment returns are produced by those businesses where fund managers have significant personal stakes.”
Fund supermarket Hargreaves Lansdown also considers it an important characteristic. One of its multi-manager funds even invests in other funds predominantly where the fund managers have some form of skin in the game. “Fund managers who invest in their own funds are giving an additional personal commitment, in that their own wealth and financial wellbeing is directly linked to the performance of the fund. This is one of a number of things we look out for when picking funds for clients,” says Danny.
Potential conflicts of interest
Yet, investing in your own fund can bring with it conflicts of interest. In some cases it can lead to improper trading; managers may take on too much short-term risk if a fund is underperforming, or even too little risk if they are nearing retirement themselves. Some managers may not want to participate in their own funds because their entire life – their job and personal wealth – is intrinsically linked to the stock market. If their fund fails, their livelihood is at risk.
Furthermore, fund managers have to be very careful of conflicts of interest when investing in shares of a parent or subsidiary company. “Generally speaking, an asset manager would not buy shares in a parent company,” says Danny.
Self-investment is also not necessarily indicative of good performance. “A manager investing in their own fund says they are trying to engender good stewardship of capital, but it is not a rubber stamp that their incentives are aligned with those of the investors, or that they’ll do a good job,” says Rory. “It demonstrates good intentions, but doesn’t guarantee good long-term performance, which is also driven by the quality of the people, the process, philosophy and price structure.” Performance-based pay that rewards good long-term, risk-adjusted performance is one way of ensuring that managers’ incentives are aligned with investors’.
“I think there is a general view that shareholders do like to see fund managers investing in their own companies as it aligns everyone’s interests,” says Annabel Brodie-Smith, communications director at the Association of Investment Companies. “But equally, I have heard fund managers make very good cases as to why they don’t invest in their own funds. I don’t think there is one easy answer.”
Reasons why managers do not invest their own capital could include the fact that “the investment vehicle that they’re running isn’t suitable for their risk tolerance”, says Rory.
Ultimately, if an investment opportunity is good enough, it seems nonsensical that investors should shun a fund just because the manager doesn’t have any personal money invested in it. “If somebody was a brilliant fund manager yet they didn’t have skin in the game, people are still going to invest with them,” says Annabel. “I think we need to keep things in perspective.”