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Skin in the Game

Don Phillips: Manager-ownership disclosure will likely spur many fund companies to encourage manager investment.

Don Phillips, 02/18/2010

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For more than 20 years, I've heard managers boast that having their own money in their fund made them work harder. Until recently, this was a virtue that any manager could claim, but few had to prove. That all changed in the wake of the U.S. fund industry's market-timing scandals. Having been caught fleecing shareholders, the industry was ill-positioned to argue against consumer advocates calling for more disclosure, even disclosure such as manager ownership that admittedly had little or nothing to do with market-timing.

Against the vehement objections of most large fund families (boutique shops, in contrast, often supported the disclosure), regulators required manager-ownership disclosure in the broad bands seen in the accompanying chart. Two lessons emerge from this disclosure, especially when it's linked to fund performance, as my colleague Karen Dolan did in a presentation at the 2009 FPA conference. One is that there's a correlation between manager ownership and fund performance. Investors who seek funds in which managers are willing to invest their own money seem to significantly tilt the odds in their favor. The correlation is absolute and significant. Among equity funds, the correlation of better returns is stronger with manager ownership than it is with low costs.

The second, more disturbing finding is that the industry had something to hide. A huge number of managers don't have a penny of their own capital invested in the funds that they oversee. Sure, there are legitimate reasons why a manager of a very specialized fund might be hesitant to have a large stake in his fund, but to have no money at all on the line is unjustifiable. The industry is creating too many funds that its most knowledgeable participants--the funds' managers--won't buy themselves, at least not on the terms that they're offered to the public. (Occasionally, we find managers who believe in their stock-picking but don't want to pay the fees associated with their funds, so they buy separate accounts that mirror their funds' picks at a lower cost.) The new disclosure exposes this lack of alignment between managers and shareholders.

(View the related graphic here.)

My guess is that the situation will change rapidly. Sunlight being the best disinfectant, manager-ownership disclosure will likely spur many fund companies to encourage managers to have more skin in the game, at least for appearance's sake--we're already hearing of manager bonuses being paid partly in fund shares. I suspect that most managers will have at least a moderate investment in most of their funds in the near future. (Exceptions like out-of-state municipal-bond funds will remain, of course.) This will probably make the utility of seeking managers with stakes in their funds less useful, but it could also lead to improved overall performance, more-prudent risk-taking, and lower costs. Managers might more actively control risks and costs if their own money is on the line. After all, owners and renters behave differently: Nobody washes a rental car.

If I'm right about the industry's response, what initially looks to be a blemish on the U.S. fund industry could turn into a gold star. No other country requires manager-ownership disclosure, so the U.S. fund industry deserves credit for addressing an issue that other countries willfully ignore. Even if other fund markets did have this disclosure, I suspect that the numbers would be even worse abroad. The United States has a far higher number of boutique or pure-play fund managers (where ownership tends to be high) and a smaller percentage of funds run by financial conglomerates (where manager ownership tends to be low). If U.S. managers up their participation in the wake of these dismal findings, it's likely that U.S. funds will put even more distance between their practices and those of the rest of the world.

Congratulations to U.S. regulators for requiring this new disclosure, and kudos to advisors who make manager ownership a prerequisite for putting their clients' money into funds. Finally, the U.S. fund industry deserves credit if its practices improve. These are signs of a healthy and vibrant industry. Regulators in other countries would be wise to consider similar disclosure. No other action promises as many benefits to investors at such a tiny cost. Little good comes from an industry that peddles products that its own members wouldn't buy. But when an industry's interests are aligned with clients', everyone benefits.

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