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Should you only pick funds whose managers have ‘skin in the game’?

17 June 2024

While most fund selectors prefer portfolio managers to eat their own cooking, it can be a minefield, experts warn.

By Jean-Baptiste Andrieux,

Reporter, Trustnet

Investors may feel dismayed upon learning that their fund manager does not personally invest in his or her fund. Their interests might not be aligned  if the manager does not win or lose money in the same way they do.

It is, in a sense, akin to a chef refusing to eat their own cooking, which clients might find suspicious. It could also indicate a lack of conviction in the investment strategy.

This concern is not limited to retail investors, as wealth managers also prefer managers who have ‘skin in the game’.

Kamal Warraich, head of fund selection at Canaccord Genuity Wealth Management, said: “There is some evidence that suggests fund managers who ‘co-invest’ alongside their investors have generated better returns, although the studies are not clear cut.

“But we do like to see managers eat their own cooking, purely because there is more of a chance they will take great care as a steward of clients’ capital. It may not make them a better investor, but it should cause them to focus more on ‘real risks’, such as permanent capital loss.”

Meera Hearden, investment director at Parmenion, also believes in skin in the game, because it is a clear indication of a manager’s commitment to their fund.

 “It also shows the manager is genuinely in it for the long haul and the conviction they have in their own philosophy, process and ability to deliver above average performance, in a risk-measured way,” she explained.

“When fund managers are tied to the firms they work for through equity as well as investment in their own funds, it signals alignment and long-term commitment, so there’s less likelihood of them jumping ship.”

Should you steer clear of managers who don’t invest in their own funds?

Lacking skin in the game is not always an instant deal-breaker; there are other ways to incentivise a manager to deliver for their investors.

Warraich said: “It is quite common for managers to have long-term incentive structures, such as a bonus (or part of a bonus) linked to medium or long-term outperformance of the fund.”

Hearden relies on conversations with fund management teams to identify whether there is a good culture and rapport.

“This can be very subjective so good communication at all times is important to ensure you’ve got the reassurance you need,” she added.

Moreover, there are instances when a manager may have valid reasons not to be personally invested in their funds. For instance, US-based managers are not able to invest in funds domiciled in Europe due to tax reasons.

In such cases, investors can check whether their fund manager invests in a similar US-domiciled strategy. US-based managers are required to disclose the amount they invest in their funds, unlike their UK and European counterparts.

This begs the question of the size of investment and degree of conviction, given that managers based in the UK and Europe might only invest a negligible amount in their own funds, unbeknownst to their clients.

Nick Wood, head of fund research at Quilter Cheviot, said: “If I ask a UK-based fund manager if they are invested, so long as they have even the smallest amount invested, they can truthfully tell me they are and it is hard to know whether that is material or not.

“Either way, what the ‘right’ amount is can be hard to determine – we shouldn’t penalise younger investors for not having the financial ability to own a lot of their fund for example. My preference would be that, as best practice, a fund manager’s deferred bonuses get invested into their funds in all cases.”


Skin in the game also comes with downsides

Although eating your own cooking is generally seen as a positive factor, it does not offer any guarantee of better performance and can even lead to confusing or misleading situations, according to Warraich.

He said: “What if you had two identical funds in terms of process and performance, but one had a minimally invested manager, and the other had a manager who was the largest holder? Does this automatically imply that the one with the larger invested manager is ‘more aligned’ and will therefore produce better returns?

“What if one manager is simply closer to retirement and has amassed more capital than the other manager?”

Wood questioned whether a manager might prioritise their own personal interests, as the proportion of their wealth invested in the fund may influence their willingness to take risks.

Hearden added: “A manager could take too much risk in certain stocks or sectors, or indeed too little as they get closer to retirement.

“This is why we look to see what risk controls are in place and check the fund is performing in line with its mandate without any undue risks being taken.”

Finally, Hearden mentioned the increasing number of high-quality managers moving away from big fund houses to launch their own boutique businesses, which could be seen as the most genuine form of skin in the game.

She concluded: “It’s something that should be taken very seriously by fund buyers. It’s no longer just investment in the fund either directly or as part of an incentive scheme – the manager’s livelihood is now on the line.

“This can be both positive and negative, so it comes down to portfolio construction by the discretionary fund manager to manage that risk.”

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