Should fund managers invest in their own strategies?

I’ve looked at the evidence and opinions.

The data available is only patchy, yet the opinion that fund managers should invest in their own funds is widely held. An interactive investor survey showed 85% of respondents said 'skin in the game' would align fund-manager interests with their own. Some experienced fund researchers say that if they were only allowed to ask one question, they would ask if the fund manager was personally invested in their own funds. So why has this notion become so wide spread?

EVIDENCE

• Academic studies focus on the US, where it has been mandatory to report fund manager ownership since 2005. But the reporting methods and data is a bit clunky. They generally reveal that funds in which portfolio managers are personally invested often exhibit reduced risk-taking behaviour. On balance most studies also conclude that funds with high manager ownership have better risk-adjusted returns.
• Counter research from Finland finds the opposite – “results suggest that higher managerial ownership actually leads to inferior, not superior performance’’ says one study.
• Morningstar suggest that funds with high manager ownership correlate with superior returns. In fact they say it’s the second best screen for fund returns behind low fees. On average, funds with high manager ownership score about 0.5 stars more (out of five) than low manager ownership funds. Importantly though, they agree it’s no guarantee of better returns and they are inconclusive on causality.
• Lipper meanwhile doesn’t place any weight on fund manager ownership, saying there are more important things to look at.
• The Securities and Exchange Board of India (SEBI) introduced new regulation a few years ago that requires key employees of asset managers to invest a portion of their salary in the funds they oversee. As far as I am aware, that remains the only nation where it is mandatory so I would be interested to see the impact of the regulation. But if every fund manager is invested … if my math is right they can’t collectively outperform the market (in this case ignoring private and non-domestic investors).

PROS

• Incentive alignment: managers experience the same risks and rewards as their clients. Nassem Taleb’s 2018 book highlights the importance of skin in the game and says that those that do are more ethical, rational and trustworthy than those who don’t.
• Transparency and credibility: Investors appreciate managers who invest alongside them.
• Focus: having skin in the game increases focus on all aspects of the task at hand and makes us better learners. But as Joe Wiggins (CIO of Fundhouse and of author of the Behavioural Investment Blog) postulates "additional focus doesn’t transform an unskilled investor into a skilled one".
• Reduce risk taking and flow chasing: Investor flows are known to follow strong recent positive performance but slower to react to negative performance, which could incentivise excessive risk taking as fund managers seek great AUM. One study noted that “managerial ownership is an important mechanism to mitigate agency conflicts’’. i.e. reigning in temptation score one big year of performance to gain assets. In my view this risk can be, and is, mitigated with other long term targets and compensation structures.

CONS

• Managers already aligned: A fund manager’s performance will have career and compensation impacts regardless of their self-investments. By Taleb's description, this should already constitute 'skin in the game'.
• Behavioural biases: A fund manager might be less ‘cold and calculated’ when his or her personal money is at stake. This can be mitigated with a strong process in my view. I also think that unless the amounts personally invested are vast, this won't be the first thought of fund managers.
• Objective skew: the fund manager may shape the portfolio to their own objectives, not those of the clients. Again, this can be mitigated with governance and clear portfolio objectives.
• Diversification: One that’s close to my heart as a multi asset fund manager. I preach diversification. And here concentration risks can come in many forms. What if I managed a niche asset class, or one outside my risk tolerance? Should I be expected to over-concentrate in one asset class to achieve alignment with investors? And I want to diversify my life too… my industry and career is already exposed to financial markets at large, regardless of asset class, should I take less investment risk as a result to balance total ‘life portfolio’ risk?

The whole concept, including relevant data collection, is made more difficult by the rise of passive investing. The notion of fund manager ownership seems to dissolve when talking about passive funds. This is for various reasons... passive managers may run more funds, have different incentives than outperformance, and there is less expectation that they should be taking 'forced' beta risk in the asset class they manage. So at an industry level, as passive rises, does skin in the game become less relevant? And active managers face so much beta risk too, so should they be long their active positions and hedge the beta risk? After all, asset allocation is the key determinant of portfolio risks and returns.

I'M IN, BUT DON'T FORCE IT

Luckily my team runs many funds with different risk profiles and objectives so I can find one that suits my needs. The investment philosophy of the team matches mine too (one of the reasons I work there!). And I agree it feels right to self-invest. But it's important to acknowledge potential conflicts of interest and biases that might arise. Skin in the game has both merits and complexities. Whether this practice significantly enhances fund performance and client outcomes remains a nuanced question. As it stands I don't think fund managers should be forced into ownership of their own strategies. Maybe I can be convinced otherwise!

And finally, asking how much is invested is a probably unlikely to yield a helpful answer, as well as being a bit of an intrusion into someone's personal finances. As Merryn Somerset Webb put it in a 2021 article in the FT, certain amounts could be "chump change if they [fund managers] have been in the business for three decades running a reasonable sized fund that has even vaguely kept up with the market. But it could be a massive stretch — and huge vote of confidence — if they’re 35 with three kids" which is closer to the position I'm in.

For professional investors only. Capital at risk. Opinions are my own.