Do fund managers with 'skin in the game' perform better?

When thinking about investing in a fund, there will be certain questions you want answers to. You'll want to know about cost, what it invests in, the manager's track record, volatility and objectives.

But there's one question that investors tend to overlook: does the fund manager taste his or her own cooking? After all, if a fund is good enough for you to invest your own money in, surely it's good enough for the fund manager to do likewise.

While a growing number of managers are vocal about the merits of having "skin in the game", others insist that it's immaterial. Indeed, some say there are risks to having a personal interest in a fund, and dangers for investors in reading too much into its significance.

Should you trust managers without?

So should manager holdings be something investors look for before putting money into a fund, or is it purely symbolic and irrelevant to the returns they'll get?

One of the most outspoken advocates of fund managers sampling their own cooking is Terry Smith. The founder and chief executive of Fundsmith now has around £200 million invested in his own funds, having ploughed £25 million into the Fundsmith Equity product at launch in 2010.

The US SEC requires managers to disclose how much they invest in their own fundsSmith finds it "astonishing" that many managers don't invest in their own funds and has said that he "wouldn't trust" such managers. He believes strongly that disclosure of manager holdings should be mandatory.

But rules governing disclosure of manager and director holdings vary with country and fund type. The Securities and Exchange Commission in the US requires managers to disclose how much they invest in their own funds, for example.

Since the rule took effect in 2006 there has been a marked increase in the number of managers prepared to take the plunge. Investment trusts have similar disclosure rules, due to their public company status.

As it stands, however, there is no obligation on UK-listed open-ended funds to do likewise - and Smith thinks that's unlikely to change any time soon.

"The UK asset management sector always seems to fight against any form of mandatory disclosure which would increase transparency for investors. It has done so on fees and costs, and would probably do so on this," he says.

In a study of 260 UK-listed trusts, only 48 had managers with over £1 million investedCanaccord Genuity research published in early 2015 looked at board stakes in their own investment trusts and included data on manager shareholdings, where available.

It revealed that of 260 investment companies, there were 48 where managers of investment teams had personal investments of more than £1 million (as of December 2014).

While it was "encouraging to see many directors and managers with material investments", the report said, "there is a marked polarisation, and the apparent lack of conviction by some does not sit easily with the degree of commitment expected by investors".

Which firms encourage their managers?

Firms including Liontrust, Jupiter, Crux and Cazenove either encourage or require their managers to invest in their own funds.

Neil Woodford, of Woodford Investment Management, has a substantial sum of money in his own equity income fund, while Nick Train of Lindsell Train and Sebastian Lyon of Troy Asset Management are among other well-known managers with large stakes in the vehicles they manage.

More than just having their own money in the fund, it is about an alignment of interestsAt Henderson there's no mandatory "skin in the game" policy, but several of its managers have shares in their own trusts, including Neil Hermon (Henderson Smaller Companies) and Job Curtis (City of London).

One firm in which all managers have significant positions in their own funds is Edinburgh-based Saracen. Chief executive Graham Campbell believes it's about the firm's interests being aligned with those of its investors.

"I view this as more than just having their own money in the fund; it is about an alignment of interests, and this can be achieved in several ways. It works much better if the manager has a meaningful (to them) amount of money in the fund."

Too many eggs in one basket

But there are many in the industry who hold less store by managers investing their own money in the funds they run. Some argue that by investing their own money in the funds on which their careers depend, managers may be putting too many eggs in one basket.

Then there's the emotional factor: are decisions likely to be as clear-headed during times of volatility when there's a personal stake at risk?

While "skin in the game" may demonstrate good intentions, Rory McPherson, head of investment strategy at Psigma Investment Management, points out that good long-term performance is also driven by the quality of the people, the process, philosophy and price structure.

'With their own money at stake, why would they become less ruthless about selling positions?'"It isn't a rubber stamp that ensures superior performance," he says.

McPherson sees a downside to the idea that managers with skin in the game will invest a fund's assets with more care.

"For instance, managers may become overly cautious as they grow older/richer or their lifestyle changes, and seek to aggressively protect or punt capital in a way that deviates from the 'value-added' that created their wealth in the first place," he says.

So while skin in the game can be a good thing, any view needs to be taken on a case-by-case basis. But Terry Smith doesn't see any negatives to managers investing their own money in their funds.

"The point about the possibility of the manager falling in love with holdings within the fund is a red herring. With their own money at stake, why would they become less ruthless about selling positions?

"It strikes me as self-evident that it should make a difference whether fund managers have their own money invested in the fund they manage."

Correlation between 'skin in the game' and performance

The absence of any obligation on UK fund firms to disclose how much their managers invest in their own funds means there is no comprehensive data on the correlation between "skin in the game" and fund performance.

There is a disclosure rule in the US, however, allowing for some analysis of the performance correlation. Morningstar US research, using SEC data on manager holdings, found that where managers invested more than $1 million (£820,000) in their funds, the performance was better.

Managers who see their funds as just 'a product to sell' may be less likely to believe in the strategyThe study, by Russel Kinnel, director of fund research, covered a five-year period from 2009 and compared performance between different levels of manager ownership (from $110,000 up to the $1 million-plus band), excluding index funds and funds of funds.

Managers who invested more than $1 million typically had a better success rate than those who invested nothing, the data showed, with the performance improving as personal investment levels increased.

The report says managers with significant holdings in their own funds were more likely to believe strongly in the strategy. In contrast, those who saw their fund merely as a "product to be sold" might not have that commitment.

Firm profile: Crux Asset Management

Employee-owned investment boutique Crux Asset Management believes managers should have holdings in the funds they run. All employees are shareholders and are required to invest 25% of dividends from their shares into Crux funds for a minimum three years.

Marketing and communications director Giles Kidd-May explains: "We firmly believe that fund managers should have the courage of their convictions and make investments in their own funds: all Crux managers have significant personal holdings in the funds they manage."

'Some of the best returns are produced where managers have real personal stakes'If managers don't put personal assets into their funds, it raises the question of whether they fully believe in their own ability, notes Kidd-May.

"Furthermore, making investment decisions in other private portfolios is a distraction for a fund manager: investors are much better served if the fund manager's best ideas go into the funds for which they are accountable, rather than a personal investment account."

One argument against managers investing in their own funds is that their decision-making might be affected by an emotional attachment to their holdings. But good fund managers don't get attached to the stocks they own, insists Kidd-May.

On the contrary, he argues, the personal element helps keep fund managers more focused.

"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, not only in the funds they manage but also in the fund management house for which they work."

This article was originally published in our sister magazine Money Observer. Click here to subscribe.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.