Most portfolio managers shun their own funds

Helpful hint for mutual fund portfolio managers: Get some skin in the game if you want to outperform other managers. According to a series of recent studies by Morningstar Inc., funds whose managers invest $1 million or more of their own money in their fund ranked in the 42nd performance percentile, on average, over the five-year period through July. That means they outperformed 58% of their peers. Funds whose managers own no shares ranked, on average, in the 54th percentile. Morningstar also found that in 51% of the 4,383 funds it has tracked for manager ownership levels over the past five years, fund managers owned no stake at all. Having a stake in a mutual fund means that managers have their interests “truly aligned with shareholders',” said Karen Dolan, director of fund analysis at Morningstar. “The best managers that we've followed and respect a lot tout the fact that they're investing alongside investors. They find their funds the most attractive” place to invest their own money, Ms. Dolan said. “It doesn't surprise me at all that funds with managers purchasing their own funds tend to perform better,” said Samuel Baldwin, an adviser with Spencer Financial LLC, which has $100 million in client assets.
“We don't like to recommend things that we aren't investing in ourselves,” he said, adding that mutual fund managers should be doing the same. Ownership stakes are “critically important in terms of evaluating fund managers,” said Jonathan Kelley, a partner at Hinds Financial Group Inc., which manages $175 million. He also looks at the fund holdings held by mutual fund directors. The fact that more than half of the funds tracked by Morningstar for ownership stakes have no manager investment at all is surprising, observers said. “It really doesn't make any sense,” said Vern Sumnicht, chief executive of Sumnicht & Associates LLC, which manages $300 million for clients.”The manager [without any shares] obviously doesn't believe in what he's doing.” Just 413 funds out of the 4,383 total have portfolio managers with more than $1 million invested in them. Although manager ownership and performance appear to be correlated, Ms. Dolan said, it's not yet clear whether ownership levels are predictive of future returns. “We would want [to analyze] more time periods [to] see what a manager owned five years ago and then see how they performed,” she said, adding it's possible that some managers bought more shares after performance improved. “But I would not be the least bit surprised if [manager ownership levels were] predictive” of performance, Ms. Dolan said. “I think we will see a strong relationship moving forward. I don't think it's chance.” Managers who have large stakes in their funds tend to have strong beliefs in their strategies and stay committed to their fund and their fund company, she said. “Those are the characteristics that come with managers who do well,” Ms. Dolan said. Mr. Sumnicht agrees. A money management shop “that is well-run, where people are happy and really want to work, and where the [investment] team is consistent through time,” tend to do better, he said. Since 2005, the SEC has required funds to disclose a range of manager ownership levels. Morningstar has incorporated that information into its stewardship grades but only recently analyzed manager ownership data separately. “It's definitely a sensitive issue [for the fund industry],” Ms. Dolan said. “For the most part, they have excuses” about why managers own few shares. She did note, however, that some of the arguments are legitimate. For example, a New York-based manager of a California tax-free fund might have no reason to invest. Similarly, offshore managers may not be able to own U.S. funds. And arguably, an older portfolio manager running a growth-oriented fund may not want to have a large stake, Ms. Dolan said.
On the other hand, Ms. Dolan pointed to Martin Whitman, the 84-year-old founder of Third Avenue Management LLC, who put $3 million of his personal wealth into his Third Avenue Value Fund last March because he saw an opportunity in distressed debt. He was quite vocal about adding to his own stake. Conversely, younger managers may not have the resources to build huge positions. “But why shouldn't a 45-year-old [manager] have at least several hundred thousand dollars in [a broad-based] fund he manages?” Mr. Kelley said. Even managers of sector or specialty funds should have a “meaningful stake,” Ms. Dolan said. “How you define that could vary, but it's something more than zero.” Some managers may invest in their strategies, she noted, but through a separate-account platform at lower cost than the public fund. “Managers should have the same experience as fund shareholders,” she said. “And I don't buy other excuses for not having a large stake, like [New York] real estate being expensive. It's not that they don't have the money.” The ownership picture may change as more attention is paid to the issue. Some fund groups, for example, are paying bonuses in fund shares, Ms. Dolan said, because fund companies “won't want to see their managers at zero.” E-mail Dan Jamieson at djamieson@investmentnews.com.