It is well established that the average active fund manager underperforms their benchmark, and that a manager who has put in a market-beating performance in the past is no more or less likely to beat the average in the future. Given these bald numerical facts, the continuing rise of low-cost index tracker funds is inevitable and to be welcomed.
But what if there was a reliable way for investors to identify fund managers who could be expected to beat the market over the long run? That might throw a lifeline to the beleaguered active fund management industry. It would also bring investors a handy extra return.
There is a flicker of a chance that an obscure line item in the regulatory filings that mutual funds have to send to their investors might contain such a clue.
The Securities and Exchange Commission requires that funds disclose annually approximately how much money each portfolio manager has invested in the fund. A handful of studies this year have found that funds in which the manager has significant skin in the game might outperform those where the manager is not heavily invested.
That sounds intuitive. In fact, it has become something of a guiding principle in other areas of business and finance. Equity investors like to see that the chief executives of the companies in which they invest have a decent shareholding; they like to see remuneration packages that include lots of stock compensation; and insider share sales are often seen as a red flag for impending problems.
In hedge funds, too, investors can stomach the high fees knowing that a manager usually has most of his net wealth tied up in the fund. In a system of principals and agents, the alignment of interests is vital.
It should not be overstated, however. Even mutual fund managers who have not put significant sums into their own funds get bonus compensation, pay rises and industry plaudits when they do well by their investors. Anyone who underperforms for very long gets fired. Interests are hardly misaligned.
A study this month found an investor is likely to beat the average by some distance if they pick funds from an asset management firm whose portfolio managers are heavily invested in their funds.
The source is hardly impartial in the active/passive debate. Capital Group, the company behind the historic American Funds family, has lost substantial market share to the purveyors of index funds in recent years.
Yet Capital’s contribution is intriguing. It ranked asset management firms according to the proportion of their assets that are in funds where the portfolio manager has at least $1m of his or her own money in the fund, and then looked at how the top quarter of those firms have done over the past 20 years. On a rolling five-year or 10-year view, their funds beat their benchmark more than two-thirds of the time.
The findings echo a study that Morningstar, the mutual fund research group, did earlier this year.
Both concluded, in other words, that if you only pick funds from companies whose managers have the most skin in the game, you substantially improve your odds of beating the market.
The two studies aggregate manager ownership data at the company level, not at the fund level. This might be fair. No investor should be piling large portions of their net worth into frontier markets or junk bonds, so it is not reasonable to demand the same of the managers of these niche funds. But it does undercut the logic. Many of the managers being measured will not in fact have the skin in the game we want to believe is motivating them.
Maybe the positive effects seen at the company level suggest a strong corporate culture, perhaps including the ability to retain good managers; that is certainly what Capital Group would have us believe.
But what of fund level data? Morningstar analyst Russel Kinnel examined its “Morningstar 500” of favoured funds – a list inaugurated in 2006 – and discovered that, of those whose managers have $1m-plus invested, 67 per cent had survived and beat the average of their peers over the past eight years. That may sound like a strong result, except that 60 per cent of the rest of the funds also outperformed.
The best to be said at this point is that more study is needed. And more data. A manager is currently only expected to say which band their ownership falls in: zero, $1-$10,000, $10,001-$50,000, $50,001-$100,000, $100,001-$500,000, $500,001-$1m or above $1m. It would be helpful if mutual funds voluntarily disclosed – or the SEC mandated – more detail. Active managers have nothing to lose from providing more granular data, and potentially much to gain.