Alpha Ideas

(Hat Tip Prashant)

If you didn’t have the data, you might reasonably assume that any fund manager worth his salt was heavily invested in his own fund. This ought to apply to an overwhelming percentage of all the actively managed funds out there. In fact, as a recent article in Barron’s points out, it’s the exception rather than the rule. Using data from Morningstar, they find that almost half the funds tracked were led by a manager with no money invested at all. This sorry bunch may think they’re good, and their marketing materials presumably make the case, but by investing their own money elsewhere they tell you what they really think.

And of the 7,700 funds tracked by Morningstar, only 910 had a personal investment by the manager of at least $1 million. This isn’t a high hurdle; less than this threshold either means the manager doesn’t have $1 million to invest, a paucity of personal resources that should give any potential client pause, or chooses not to.

It’s not just that it feels right to know your manager is invested alongside you. For the client, this is the only way to ensure alignment of interests and protect themselves from the principal-agent problem so prevalent in finance. If you’re a fund manager only managing OPM (Other People’s Money), your compensation is fully linked to the size of the fund you manage. The most reliable way to grow your fund is to outperform your competition. A seductively simple way to outperform is to take more risk than the others. Because if you take more risk in a rising market, you will assuredly do better than most and money, which chases performance, will follow. If the market goes down and you underperform, you haven’t lost much because it’s only your clients that suffer the returns. And if performance is really bad, you can always start a different fund.

For the investor, it’s not a bad rule to simply eliminate from consideration any investment manager not personally and significantly invested in his own strategy. It makes intuitive sense but it also provides for an alignment of interests. Don’t let the uninvested take advantage of you.-from SL Advisors