Should Fund Managers Invest in Their Own Funds?

Pros I am of two minds about the precept that fund managers should "eat their own cooking."

Endorsing the notion is its popularity. That an investment is well-liked is a drawback, not a recommendation. But investment principles are different matters. Most of the time, when people agree on a common investment principle, they are correct. Examples would be to keep costs and portfolio turnover low; avoid get-rich-quick pitches; trade only when necessary. All common counsel—and sound advice.

There is also some supporting evidence for manager ownership. Anecdotally, Jack Bogle maintains that investment partnerships, which tend to have relatively high rates of manager ownership, tend to post better results than other types of fund companies. More rigorously, American Funds has run the numbers to show that stock funds with low costs that are sponsored by companies with above-average levels of manager ownership have strong performance.

Certainly, my coworkers believe that the subject is important. Morningstar spurred the Securities and Exchange Commission to require that mutual fund companies divulge such information. Morningstar then collected the figures when they were released and turned them into data points. It then wrote reports on those findings.

Cons However, there is a large drawback: The idea doesn't make much sense.

To start, the math doesn’t work. Consider the stock-fund manager who runs a $500 million fund, and who has invested $1 million in that fund’s shares. The fund’s benchmark gains 7%, annualized, over the next five years. If the fund matches the benchmark, after expenses, the manager’s personal stake grows to $1.4 million. If the fund exceeds the benchmark by 3 percentage points per year, that holding becomes $1.61 million.

That extra $210,000 is a pittance compared with the career benefits. An active manager who matches the index after expenses has done all right. He will likely keep his job, and because the fund will increase in assets due to internal growth, he will receive modest raises along the way. In contrast, an active manager who beats the index by 300 basis points per year, for half a decade, becomes a star. His fund might grow tenfold, his salary will certainly more than double, and the executive recruiters will be calling.

Besides the money, there’s pride. Fund managers are no different than the rest of us; they like to believe that they are good at their jobs, and enjoy being recognized as such. Unlike most employees, though, they are publicly graded according to widely accepted measures—for example, by their funds’ total returns, or its Morningstar star rating. Who wants to be known as the chief of a 1-star fund?

Even if one disregards those two arguments, in the mistaken beliefs that the incremental investment gains mean more to the manager’s personal portfolio than to his career prospects, and that job satisfaction is relatively unimportant, there remains the difficulty of linking motivation to investment success. Where is it written that desire creates profits? Many investment managers are motivated to succeed. Few do.

American Century's Case Last week, Internet writer Joshua Brown ("The Reformed Broker") added a new twist to the subject. American Century was recently sued for using its own, proprietary funds in the company's 401(k) plan. Brown finds that action ironic: "How Dare You Make Us Eat Our Own Cooking!"

He writes:

Imagine a homebuilder who wouldn't raise his family under a roof that he himself had raised. A fitness instructor who doesn't do his own workouts. A nutritionist who swears by somebody else's diet plan rather than the one she recommends to her clientele.

But in the asset management industry, it's becoming de rigueur. The fund complex knows it's full of [manure] and that the product fails more often than it works, after taxes and fees. The employees of these firms are fighting back when they are forced to use the very products that they make and sell for the investor community. They're furious for have been forced to eat their own cooking.

It's an arresting picture: The company sued by its employees because the organization insists that its workers hold in their retirement accounts the investments that those employees create and sell, for other people to own in their retirement accounts. How ironic.

The tale is a bit different than it seems, though. For one, the two investors on whose behalf the lawsuit was filed do not work at American Century. They did once, but have not been there for several years. Thus, this is not a tale of cooks who do not wish to consume their own food; it is that of customers who have a beef with the kitchen. (And, possibly, with their former employers.)

In addition, the filing’s main charge is only indirectly about the quality of company’s funds. The complaint is that the plan charges too much for its size—an all-in cost, including plan fees as well as fund expenses, of 0.68% of participant assets, as opposed to an average cost of 0.44% for similarly sized 401(k) plans. This occurs in part because American Century uses registered funds within its 401(k), rather than lower-cost separate accounts. Had it created such accounts, its costs would likely be in line with those of other plans.

As for the funds’ performances, the suit does not allege overall problems. It claims that American Century was slow to replace the weakest-performing funds in the lineup, which might well have been so. (Offering a wide variety of asset classes within a single fund family pretty much guarantees that at any given time, some funds will have poor relative numbers.) Nevertheless, the lineup looks to have been competitive. By my count, 14 funds beat their benchmark indexes, after expenses, over the trailing five years, and 15 lagged.

Color Me Neutral I do not oppose the contention that managers should own shares in the funds that they run. I see no harm in the practice, assuming that the fund suits that manager's personal situation (there's no sense in a 20-something manager investing heavily in her short-term bond fund). Perhaps it will even prove to be a benefit. But I cannot hold much conviction in its power, because the underlying logic cannot withstand scrutiny.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.