Investing in funds: is the manager on board?

There are many conflicts of interest in the financial industry that investors need to watch out for. But one of the most persistent and insidious is in how fund managers get paid. Most managers get the bulk of their pay based on how much money they manage (their assets under management, or AUM). The problem is that “gathering” assets – ie, getting as many people as possible to buy your fund – involves different skills and priorities from investing for the best returns. There is, of course, an overlap – a strong track record will help persuade people to invest with you. But it can also work against investors’ best interests.

For example, say you run a fund investing in tiny companies (microcaps). Your AUM has to stay small – if you have billions of pounds under management, you simply won’t be able to invest in such small stocks. So if your strong performance in microcap stockpicking attracts a flood of cash to your fund, you have a dilemma. Do you cap the AUM, stick with the strategy, and leave all that money on the table, or do you extend your strategy into areas you aren’t quite as comfortable with to boost your own pay packet? In short – do you focus on returns, or asset-gathering?

The answer, according to a new research paper by Arpit Gupta of NYU Stern and Kunal Sachdeva of Columbia Business School, is that it depends on how much money a manager has invested in the fund. They looked at the performance of US hedge funds between 2011 and 2016. They found that funds where insiders owned more than 20% of the AUM outperformed those with little or no “inside capital”. The key difference was that funds whose managers had capital invested made sure their funds did not outgrow their strategy, so that they could always maintain a focus on their best ideas.

In other words, if a manager has a lot of their own money at stake, then they will focus on beating the market, rather than attracting new cash. Gupta and Sachdeva’s research is aimed mainly at institutions, but it echoes a study of US mutual funds between 2009 and 2014 by Russel Kinnel of Morningstar, which found that managers with over $1m of their own money in their funds beat their peers.

So if you want to invest with an active manager, look for those who invest in their own fund – if they don’t, then you shouldn’t either. Secondly, favour smaller fund houses (or “boutiques”), where the focus remains on performance, not asset gathering (though be watchful for change on that front). Thirdly, it’s another good reason to favour investment trusts, many are vehicles for family wealth; RIT Capital Partners (LSE: RCP) is almost 20% owned by the Rothschilds.