‘Skin in the game’

A check-list for evaluating fund managers

Are a fund manager’s interests aligned with your own? A great way to find out is to check whether they have their own money invested in the funds they manage.

As renowned UK fund manager Terry Smith of Fundsmith fame once asked, “Who would trust a chef who wouldn’t eat his/her own cooking?” The analogy was aimed at fund managers who don’t have a considerable amount of their own savings invested in the fund they’re trying to sell to you. If they don’t put their money where their mouth is, why should you trust them to have your best interests at heart?

It stands to reason that a manager who invests alongside his or her investors will have a greater incentive to perform well vis-à-vis a manager who just collects the management fees. But as anyone who has dabbled in the mutual fund space will very well know, managers with a significant personal stake (by which we mean material relative to their own personal wealth) in their own funds are few and far between.

However, when you do find one of these rare breed of managers, you should pay close attention to them as the data suggests they tend to produce superior investment performance.

Skin in the game leads to outperformance

A study conducted by researchers from NYU and Colombia found that hedge funds with larger investments from insiders tend to outperform those purely funded with external capital. The study also revealed that funds run by managers with more “skin in the game” exhibit superior return persistence, and their capital flows are less sensitive to return variability.

Having examined the characteristics and performance of 720 hedge funds, authors of the paper Arpit Gupta and Kunal Sachdeva found that funds with no outside capital and managed solely on a proprietary basis earned 4.3% higher excess returns annually compared to funds with only outside investment. Moreover, their research showed these funds outperformed on a risk adjusted basis, with just one standard-deviation increase in investment resulting in 1.4% to 1.7% in excess returns annually.

Unsurprisingly, the researchers concluded that better alignment of investors’ and managers’ interests could only result in better results. However, what is perhaps a surprise to readers is that the study also found that these funds kept their AuM (assets under management) on the smaller side, even when more outside investment was easily attainable.

When more than 20% of funds were owned by insiders, the managers did not raise additional capital even after periods of positive excess performance. Crucially, Gupta and Sachdeva discovered this group of managers continued to outperform for longer than funds that did see additional inflows.

What this shows is that managers that have a significant portion of their net worth tied up in their fund have a vested interest in making sure they continue to achieve the best possible excess returns – which often means limiting the size of their AuM in order to preserve their edge. These managers have their financial upside pegged to the performance of the funds rather than simply the fees collected from the AuM. Conversely, managers who focus on AuM growth as a means to increase their financial rewards are naturally less focused on performance and are often at risk of style drift as they look to extend their pool of investible assets as AuM grows.  

Skin in the game checklist

If you want to ensure your chosen fund has the best chance of producing excess returns, then it’s worth quizzing your fund manager on the following questions. And remember, don’t shy away from pushing them hard – it’s a great privilege to be entrusted with someone’s money and managers should be aware of this.

  • How much of their own money does the manager have invested? And crucially, what percentage of their net worth is invested? Yes, this is a personal question, and the manager may offer some vague answer such as “it’s a significant amount”. A USD $1 million investment may sound like a lot, but if the manager’s net worth is USD $500 million, is it really that significant for them?

  • How big does the manager intend to grow the fund? As the above research shows, managers that focus on AuM growth instead of performance tend to produce lacklustre returns for investors. Is there a soft close after a certain AuM threshold is reached?

  • Will the strategy evolve as the fund gets bigger? A manager’s edge may be eroded as AuM grows, especially in the small-cap space, because this means finding a home for more capital, which could mean broadening the investment universe and becoming less focused.

If you do come across an opportunity to get in at an early stage with a fund where the manager has a convincing strategy and track record alongside having considerable skin in the game, then this is the kind of situation you’ll want to research thoroughly and give serious consideration to. Skin in the game is by no means a guarantee of outperformance, but the data shows that it can at least tilt the odds in your favour.

Disclaimer: This blog is intended for informational purposes only. This blog is not intended to invite, induce or encourage any persons to engage in any investment activities and is not a solicitation or an offer to buy or sell any stock, investment product or other financial instruments. If in doubt, please seek financial advice from an independent financial adviser. Sarnia Asset Management is licensed by the Guernsey Financial Services Commission (GFSC). Past performance is not an indication of future returns. Investments carry risk, including the risk that you will not recover the sum that you invested.

By James Faulkner

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