KIM: Managers with skin in game most likely to perform well

When was the last time you washed your rental car while on vacation? If you’re like me, the answer is never. Why? I don’t own it. I don’t care if it’s dirty. Likewise, I park in the closest parking space, no matter how close the cars on either side are.

I know I’m returning it to the rental car company at the end of the week. In other words, I have no skin in the game.

Contrast this with my own weekend car. I wash it regularly and have it detailed periodically. I drive my family crazy with how far away I’ll park to avoid even being in the vicinity of another car. I’m going to own it for a long time and want it to look as nice as the day I drove it off the lot. You get the picture.

The same analogy can be made with investing and investment managers. It seems perfectly logical that you want to invest with a manager or fund where the manager has a significant amount invested alongside you.

Why? The manager’s financial interests are aligned with yours and the higher that level of financial commitment by the manager, the more closely your interests are aligned. Managers who “eat their own cooking” sit at the same table and eat the same meal as their investors. When the cooking is good, the manager benefits along with the investor. Similarly, when the cooking is not so good, both get indigestion.

Morningstar has studied manager ownership and its correlation with investment returns extensively since 2004. Starting in 2005, the U.S. Securities and Exchange Commission has required mutual funds to report how much their portfolio managers have invested in the funds. This information is found in a mutual fund’s annual Statement of Additional Information.

It may surprise you just how few managers and funds “walk the talk” of sharing their investors’ financial interests. In a 2010 study, Morningstar looked at manager holdings of “core” funds (i.e. excluding sector and other non-diversified funds). Forty-five percent of core stock funds and 66 percent of core bond funds had no manager ownership.

Slicing the data further, Morningstar found that while 45 percent of core stock funds had no manager ownership, only 23 percent of core stock fund assets were invested in those funds. Similarly, while 66 percent of core bond funds had no manager ownership, only 33 percent of core bond fund assets were invested in those funds.

Further, while only 13 percent of core stock funds had at least one manager with more than $1 million invested, 47 percent of core stock assets were invested in those funds. Just 3 percent of core bond funds had at least one manager with more than $1 million invested, but 30 percent of core bond assets were invested in those funds.

The reason this isn’t just an interesting bit of investment trivia is Morningstar found there is a strong correlation between manager ownership and investment performance. Specifically, the average three-year percentile ranking of core stock funds with no manager ownership was 50 (right at the median). However, funds with manager ownership greater than $1 million had a percentile ranking for the same period of 38, significantly better performance.

Correlation, of course, isn’t the same as cause and effect. Still, if managers truly believe in their products, they should be invested alongside you. The next time somebody is pitching you on an investment product, ask the person how much money he or she has invested in it. You may be surprised at the answer.•

__________

Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Ind. He can be reached at (812) 376-9444 or Mickey@kirrmarr.com.