There is a pervasive idea in the active fund industry that a fund manager investing heavily in their own strategy is a uniformly positive signal. The more they invest the better. Not only does it mean they are invested alongside us, but they have genuine conviction in their approach. This feels right, but is it true? Probably not.

Why is this widespread assumption likely to be flawed?

Unclear Causality: Although there is some research suggesting that a link exists between the level of fund manager ownership and performance.[i] It is not entirely clear which way the causality runs. Is a fund manager investing in their own strategy a prelude to improved returns, or does a fund manager invest more after they have performed well?

Many confounding variables: It is difficult to isolate a fund manager owning a significant stake in their own strategy from other related factors such as experience (long-serving managers are more likely to have the wealth to invest) or firm size (managers working at smaller firms might have greater ability or necessity to invest in their own funds).

Chasing past performance: The type of fund managers with the ability to invest large amounts in their own funds are most likely to be those that have performed well in the past and are now responsible for a significant amount of money. Strong past performance and substantial assets under management is generally not a fantastic recipe for positive future returns. Does that mean that too much investment from a fund manager is a bad sign?

Not a sign of skill:  It is not entirely clear why fund manager ownership should be an important performance indicator. Active fund investors are looking to identify skill, do we think fund managers know whether they do or do not have skill? This seems incredibly unlikely. Many more will believe they do when they don’t than knowingly possess some form of edge.

Following overconfident fund managers:  If we make the safe assumption that there is a selection bias into fund management roles for overconfident individuals; surely it is dangerous and imprudent to believe that heavy investments into their own funds is some form of relevant validation. We are a more impartial judge than they are. 

Fund manager investment doesn’t really measure ‘skin in the game’: One compelling argument behind the benefits of skin in the game through fund ownership is that the fund manager bears the same risks as their investors, but this is usually a spurious notion. I recall working on a team earlier in my career where there was a high conviction in an experienced fund manager launching a new and niche strategy primarily because they had made a substantial personal investment into it. But their situation was entirely incomparable to ours. They were incredibly wealthy and could afford to bear the stark risks of the approach far better than we could.

Skin in the game is only effective where the responsible individuals face similar (or worse) consequences for bad outcomes. An inexperienced fund manager at a small, fledgling firm has far more skin in the game than an experienced, established manager, even if the latter is able to invest far more in their own strategy. As a standalone measure, a fund manager’s investment in their own fund is not a great indicator of skin in the game.

Prudent investors diversify: A fund manager’s salary, bonus and career should be dependent on the success of their fund. Not only does this lead to some (imperfect) alignment, it makes it imprudent for them to invest substantially in their own funds. A well-calibrated individual that understands the randomness of financial markets and the low probability of success in active fund management would probably invest away from their own strategy.

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There seems to be three possible reasons why fund investors believe that fund manager ownership is a positive sign.

1) The fund manager knows something about themselves (that they possess skill) or have some distinctive insights into a particular area of the market.

2) The fund manager bears the same risks as their investors.

3) The fund manager will focus their attention on the portfolios where their own money is invested.

Of the three, only the last seems credible and is, at best, marginal. Even if it is true, additional focus doesn’t transform an unskilled investor into a skilled one. There are also far better measures of focus (such as the number of strategies they manage, or the additional responsibilities that they hold).  

Understanding how a fund manager personally invests is interesting information and may, at times, be telling. The idea, however, that it provides a powerful predictor of future returns or measures skin in the game effectively is difficult to substantiate.

Maybe the fund managers who invest less in their own funds understand probability and diversification better than those that invest more.

[i] Khorana, A., Servaes, H., & Wedge, L. (2007). Portfolio manager ownership and fund performance. Journal of financial economics, 85(1), 179-204.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).