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China Fund Managers Eat Elsewhere

The U.S. fund industry is eager to sell you a China-themed mutual fund. Whether the people who work in the fund industry would buy such funds with their own money may be a different story, however.

Don Phillips, 11/30/2011

In addition to the hundreds of “diversified” emerging-markets funds, many of which have big bets on the China region, there are already 31 U.S. open-end mutual funds -- available, of course, in multitudes of share classes--that specialize solely in Chinese stocks. That’s a remarkable range of choices for an investment opportunity that until a few years ago wasn’t even on most American investors’ radar screens. Clearly, the fund industry stands ready to give investors exposure to this trendy investment theme and to do so in convenient, diversified packages. The ability to craft tempting products in hot areas of the market has long been an industry hallmark—recall the plethora of Europe funds launched following the fall of the Berlin Wall or the wave of Internet funds in the late 1990s.

The ability to bring products quickly to market shows good salesmanship, but that may not equate to good stewardship--again, recall the Internet funds. The real question facing fund companies isn’t if they can create something that’s sexy to sell, but if they can create funds that will prove themselves as good to have bought. One valuable litmus test for this goal is whether the people creating the funds put their own money in them. On that score, the available evidence for China funds isn’t good. In only one of the 31 China-themed funds does the fund manager have as much as $100,000 of his own capital invested in the fund, according to SEC filings. In 22 of these funds, or more than 70% of the offerings, the fund manager can’t document having even a single penny of his or her own money invested. In short, there is virtually no demonstrable effort to link managers’ fortunes with shareholders’ in these funds.

Of course, these numbers must be put in context. Some of these fund managers are not U.S. citizens and cannot buy a U.S. mutual fund. They may have a commitment to the strategy through a separate account or some other means, but if they do, it is a commitment that goes undocumented by the industry’s own disclosure choices. They could make the information public but choose not to do so. There’s simply no available evidence that these managers or the executives behind them are aligning their interests with shareholders’ by holding the same funds they tout. While the industry has taken billions of dollars into China strategies, it can show collectively far less than $1 million of management investment in them. Put another way, if you as an advisor have collectively more than $500,000 of your client assets in China-themed funds, you may well have a greater commitment to the category than all of the managers of these funds put together.

The unwillingness to align its interests with investors is the shame of the global fund industry. While some managers do invest in their own funds, far too many do not. The industry creates scores of products that its own employees simply won’t buy. In a stunning survey by Ignites, roughly 40% of industry participants said they had less than 25% of their investable assets invested in their firm’s funds. That’s a remarkable finding when you consider that there was every reason for responders to overstate their commitment to their own funds and that the survey included assets in retirement plans, which would likely be tilted toward in-house funds. The industry may boast about eating its own cooking, but it appears that seeing the meal prepared diminishes one’s appetite.

The U.S. fund industry is to be commended for making manager ownership data available. No other market requires such disclosure. Even though stock investors have long had detailed data on corporate managers’ stakes in the companies they run, this is the first time that fund investors have been offered a glimpse of the same data for fund managers. Already the evidence is compelling. Morningstar has found that manager investment is positively correlated with performance and negatively correlated with risk and cost. In other words, managers who invest in their own funds not only generate higher returns, but they do so while taking more-prudent risks and keeping costs down. Investors would be foolish to ignore these correlations. And if they choose to put their assets into funds that managers themselves won’t buy, they should recognize the risk they are taking. Whether China funds will flame out like Internet funds or develop into a major asset class is a key question facing investors. When we see growing manager investment in these funds, it may be investors’ first clue that we’re actually on the latter path.

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Don Phillips is a managing director of Morningstar, Inc.

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