Skin in the Game

Hi everyone, my name is Nick Wood, Head of Investment Fund Research at Quilter Cheviot, and welcome to the latest edition of The Fund Buyer, the podcast for all things related to the world of fund research. Before we start, my usual reminder that you can sign up to be notified about future podcasts on the Quilter Cheviot website or follow #QCFundBuyer on LinkedIn.
One of the stories that caught my attention this week was the call by Interactive Investor for fund managers to disclose how much they have invested in the funds they run. This is common in the US due to SEC regulation and is also a requirement for UK investment trust boards, although not the fund manager themselves. However, European-domiciled open-ended funds are another matter, and there is no such requirement. Today I wanted to share some thoughts on the topic and consider alignment of interests between fund manager and investors more broadly.
Whether the fund manager invests in their own fund is clearly of interest – are we as investors aligned with the manager? Whilst this isn’t declared in Europe, most managers I have asked tend to freely admit they are invested, albeit we rarely get into the detail of the size of investment. In many cases, managers will invest because they have conviction in their own abilities – it’s rare to find a fund manager who doesn’t, although perhaps that is similar to the famous statistic that suggests over three quarters of drivers think they are above average – I know I am!
Whilst choice drives some managers, others may be led by their firm, with some having part of their bonuses held back and alternatively invested in their funds over a period of time, which I think does have merit.
So, would greater transparency help investors pick funds? More broadly, the fund management industry has come a long way in its efforts to boost transparency and ensure customer outcomes are made the priority. Although much of it has been underpinned by regulation, fund groups are getting better at telling customers what they are invested in, how much it is going to cost and if they could be invested in a better share class.
On this particular issue, clearly Europe is a little behind the US. Whether it would provide a discernible benefit to potential investors is an interesting question. One would want to be able to discern what is a meaningful investment for the manger in question, and not simply tokenism. Equally, we are talking about retail funds here, but of course in the institutional world, where client mandates are being run, there is no ability to invest alongside, at best it would be into a mirrored strategy. It might also be possible to go too far. If the manager has a very significant proportion of their personal wealth invested, they may become more risk averse at the wrong point, jeopardising the other investors’ potential returns as well.
Looking across to the US where disclosure is in place, I found an interesting piece from Morningstar which had looked at over 7,000 fund disclosures and found that over a 1,000 funds had a fund manager with over $1 million invested. They also concluded that it was a significant indicator of future outperformance, so there may be something in it. I’m not sure that is quite necessarily the whole picture personally – as ever, picking a fund is a bit like piecing together a puzzle, and this is just one piece.
Expanding the theme out further, what else creates alignment of interest? A boutique structure is where you most often find the best alignment. In particular, where the firm has limited product offerings and the key investors also have a stake in the business. They are incentivised to perform well long-term for the benefit of both the fund and the broader business. That is clearly a key incentive for anyone who goes off to set up a new shop. In much larger organisations, that alignment is much less connected. With the odd exception, one fund is unlikely to drive the overall firm’s results. Another way of ensuring better alignment therefore tends to be linking pay to longer term performance outcomes, presuming this is relevant to the way the fund is managed.
One other potential measure to align interests is the performance fee. In simple terms, the fund manager does better if he generates outperformance for the client. Whilst this seems like an obvious route, in a world where the focus on fees is so acute, it hasn’t proven as popular as we might think. To take the investment trust universe as a good example, trusts have been steadily removing performance fees over time. It can also potentially have somewhat perverse incentives if a manager has done especially well or badly at particular points, and too high a performance fee might encourage excessive risk taking.
Coming back to the issue of the day, and whether fund managers should disclose holdings to the market, my view is that any additional disclosure is always helpful, so long as that doesn’t confuse the end investor. Equally, it must be set up in a way that doesn’t simply allow the system to be gamed, perhaps with an insignificant investment being sufficient to tick the box. To my mind, the best form of alignment of interest is created at the company level, more readily done at a boutique. But even for larger organisations, having the right structures and incentives in place to align with the client is certainly possible.
Whilst we are discussing this, it is also worth considering the gatekeepers, those that are picking the fund managers in the first place. The platform buy-lists in particular have come under scrutiny in recent times, and perhaps we also need to know whether those recommending particular funds to retail investors are also investing? I might just be opening up a can of worms with that suggestion though!
On that note I’m going to close today’s edition of the Fund Buyer. As ever, thanks for listening and stay safe!

Written by

Nick Wood
Head of Investment Fund Research

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