Analysis: Why some fund managers don't invest in their own funds

NEW YORK (Reuters) - If you’re an investor who owns a single share in a mutual fund, here’s a nasty little shocker: You might have more money on the line than your own fund manager.

Amazingly, many portfolio managers don’t invest in the funds they’re running. According to Chicago-based fund research firm Morningstar, 45 percent of stock funds and 66 percent of bond funds that are considered ‘core’ - basic building blocks of a portfolio, like an S&P 500 index - have a grand total of zero manager investment.

For fund shareholders, it’s like finding out the chef at your favorite restaurant doesn’t eat his or her own cooking.

“It’s very troubling,” says Laura Lutton, Morningstar’s editorial director of fund research. “Mutual funds are the key retirement-savings vehicles for most Americans, and managers get paid a lot of money to deliver returns for shareholders. When they don’t invest alongside you, that’s disappointing.”

That’s why Morningstar factors the data into its fund ratings, with management ownership representing 10 percent of its ‘stewardship’ grade. If a manager runs a core fund, he or she gets full credit for having more than a million bucks on the line, and partial credit for investing between $500,000 and a million. If it’s a non-core fund, $100,000 and up gets a manager full credit, as long as they have more than a million invested at the firm in total.

Among those fund families that score well for eating their own cooking: Dodge & Cox, American Funds, and Royce & Associates. “It aligns us with shareholders,” says Jack Fockler, managing director and one of four principals at New York-based Royce. “When they do well, we benefit. When they don’t, we suffer the same consequences. If you’re not doing that, it raises a question in my mind about what’s important to you.”

Led by founder Charles Royce, the firm is almost religious about forcing managers to put up their own money. Lead portfolio managers have to have a million dollars in their funds; co-managers, half a million. If you’re a young manager just starting out, and don’t have that kind of cash yet? Don’t worry, they’ll just keep directing your bonus into the fund until you get there.

Meanwhile, on the naughty list of fund families that Morningstar finds “disappointing”: BlackRock, where two-thirds of its U.S. funds have zero manager ownership; and bond giant PIMCO, where average manager investment in its funds is a relatively slim $97,000.

The management-ownership issue isn’t without controversy, though. Even industry Boy Scouts like Vanguard - well-known for its low-cost, shareholder-first corporate ethos - are ferocious in fighting back against Morningstar on this issue, since there’s an array of possible reasons why a manager might invest elsewhere.

“It makes little sense to me,” says Rebecca Katz, a spokeswoman for Malvern, Pennsylvania-based Vanguard (which still scores well on overall stewardship). “We believe that this isn’t a good measurement of how committed a manager is to a fund. There are so many other more important factors an investor should consider - cost, risk, performance, taxes.

“Should a muni manager living in Pennsylvania be forced to own the California tax-exempt fund, simply because he manages it? What about a bond fund manager who is in his or her 30s, and might not need significant bond exposure -- but to meet the hurdle Morningstar has set, would have to allocate a significant portion of their overall wealth to a bond fund? We don’t believe that managers should be forced into investments that don’t fit their time horizon or goals, simply to check a box.”

Other reasons for non-ownership that are often cited:

*That managers already face substantial ‘career risk’ in their funds, since if they underperform their benchmarks, they’ll likely lose their jobs

* That they’re sometimes invested in separately-managed accounts, with different options than the retail public

*That some managers steer multiple funds at the same time, making million-dollar investments in all of them impractical and potentially overlapping.

That’s why prominent fund rater Lipper, a Thomson Reuters company, doesn’t put as much stock in manager ownership. “It gives me warm feelings to see that, but it doesn’t factor into our actual methodology,” says Lipper senior analyst Tom Roseen. “It’s nice if managers have some skin in the game, but there are more important things to look at, which is why our ratings are just based on performance.”

According to Morningstar’s Lutton, though, the proof is in the pudding: Funds with high levels of manager investment simply tend to fare the best. If a manager has more than a million dollars in his or her fund, then that fund’s three-year average (under Morningstar’s five-star system) is a robust 3.45. If there’s less manager money on the line, the rating drops more than half a star. For potential investors, that’s a critical screen.

“I think the industry is starting to pay attention to this issue,” says Lutton. “And if institutional investors start to screen funds based on manager ownership, we’ll start to see changes very quickly.”