Managers who hate their own cooking

It should go without saying that the money manager you entrust with the task of managing your money should believe in the investment process he uses to manage your portfolio.

In fact, we would go further and say that he should be convicted that the investment discipline he is following is the very best process that he could possibly use for the objectives, mandates, and constraints of that portfolio.

One indication of such conviction is whether that manager actually places his own money in the securities that he selects for the clients investing in his portfolio. Doing so is commonly described as "having skin in the game" or as "eating his own cooking."

However, a recent study from Morningstar, published this week, reveals that an astonishing percentage of money managers do not have a single dollar invested in the portfolios that they manage. According to the preliminary data which encompassed approximately 6,000 mutual funds, 47% of the managers of US stock funds report no management ownership, 61% of foreign stock funds report no management ownership, and 71% of balanced funds (investing in both stocks and bonds in the same fund) report no ownership.

The author of the article linked above, which is found on a Morningstar site, notes that there are some special circumstances which would dictate that a manager not invest alongside his investors, such as if running a muni bond fund composed only of bonds from another state (and fully 80% of muni bond fund managers had zero ownership in their funds) or if the manager is from a foreign country that bars investment in fund domiciled in the US, but that beyond those two special circumstances, it's a mystery "why anyone would invest in a fund that its own manager doesn't invest in."

From our perspective as money managers, we can add the comment that, if you deeply believe that you are pursuing the very best investment discipline that you possibly can, why wouldn't you want to invest at least some of your own money in that very same process?

Furthermore, academic studies which look at the level of management ownership (as well as director ownership by members of an investment company's board of directors) confirm the common-sense hypothesis that skin in the game matters. For example, this 2006 academic study looked at director ownership and found benefits to their ownership, and this different 2006 academic study concluded that "future risk-adjusted performance is positively related to managerial ownership, with performance improving about three basis points for each basis point of managerial ownership."

We also noted in our February 1 post entitled "So when do you fire a manager?" that a portfolio manager's level of investments in his own portfolios is an important indicator of his conviction to the merits of his strategy and that he should "eat his own cooking."

This discussion is particularly timely in light of today's news in which federal authorities indicted two hedge fund managers. Among the allegations are that one of the managers began to remove about a third of the $6 million of his own money he had invested in the hedge funds that he managed, without notifying investors, nearly three months prior to the collapse of the funds in June, 2007.

We strongly believe that investors should view management ownership of portfolios in which they invest as an important indicator of conviction, and caution that management's removal of their own money -- or failure to invest in their own portfolio at all -- should be viewed as a major red flag.


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