The most important question to ask your fund manager

Picking the right fund manager to manage your assets is arguably an underrated and under-discussed process which is as complex as stock picking. As with all financial decisions, it’s important to ensure your fund managers’ strategy and process aligns with your risk appetite, return objectives, and time horizon.

You’ll also want your fund managers to have conviction in what they’re doing. On that front, there’s one question investors can ask prospective fund managers which reveals their genuine conviction level above all other questions… do you have skin in the game?

What is skin in the game?

The term ‘skin in the game’ is believed to have originated amongst the horse race gambling community who described horse owners as having skin in the game whenever their horses were competing in race events.

These days, along with ‘eating your own cooking’, the term has become synonymous with fund (or company) managers being invested in the same fund (or company) as their investors.

Why skin in the game matters

In the immortal words of Mr Buffet… ‘To be successful in business and investing you’ve got to have skin in the game, a stake in the company.’

Most investors intuitively understand why this is the case. When fund managers’ investment decisions not only affect their clients’ financial wellbeing, but also their own, they’re incentivised to bring their A-game to the management of those assets.

It’s all about conviction. If a fund manager chooses to invest a large portion of their wealth into their own fund, it’s a solid signal that their conviction in the fund’s portfolio, process, strategy, and future is as high as they say it is during marketing meetings. It’s a case of their words and actions meeting in an authentic alignment with their clients’ best interests.

Importantly, the way fund managers manage risk can also be affected by how much skin in the game they have.

If you think about the way fund managers generate management fees based upon assets under management, and performance fees based upon outperformance, they are naturally incentivised to increase risk in order to generate performance fees. So without the balancing perspective of having their own funds invested in their fund, a fund’s risk management may not be optimised for the investors in the fund.

It’s another illustration of why having skin in the game helps ensure fund managers’ interests are aligned with their clients’ best interests.

Skin in the game disclosure

The importance of fund managers having skin in the game is well recognised in the US.

In fact, the SEC requires fund managers to disclose how much of their own money is invested in their funds ‘to help investors assess the extent to which the portfolio manager’s interests are aligned with theirs.’ Just like in the listed corporate world, the consensual view is that it’s best if fund managers have substantial skin in the game to ensure their interests are aligned with their investors.

In Australia (and most developed markets outside of the US), many investors are aware that skin in the game is a valuable gauge of fund managers’ conviction levels, but there’s no easily accessible information revealing how much fund managers have invested in their own funds.

Investors certainly want this information. A recent Interactive Investor poll revealed 88% of investors believe it should be mandatory for fund managers to disclose whether they invest in the fund they are managing. The same poll revealed 77% of investors would be more likely to invest in a fund if the fund manager was personally invested in it.

This issue has not gone unnoticed. In the words of Alan Brierley, research director at Investec, publisher of the annual Skin in the Game report… ‘We strongly believe that personal share ownership sends a clear and powerful message to both existing and potential investors. Since our first Skin in the Game report in 2010, it has become the accepted norm for boards and managers to have a meaningful personal investment in companies that they represent. However, while board directors are required to disclose ownership and transactions, it is disappointing that some managers remain reluctant to do so.’

So skin in the game disclosure by fund managers is a hot topic due to the transparency gap which investors need to navigate. Don’t be dissuaded though. Where there’s a will there’s a way. .

How to find out about fund managers’ skin in the game

Whilst it’s relatively easy for investment analysts and journalists to ask companies for skin in the game information, it can be harder for individual investors to uncover the truth. It’s time for that to change. It’s time for fund managers to live by the same standards they expect from the companies they invest in. That means openly disclosing their skin in the game information to investors.

In the absence of openly disclosed skin in the game information, the best approach for individual investors is to politely ask a fund manager’s investor relations manager for this information. Forward-thinking fund management teams will generally respond positively to this question by openly disclosing the information, hopefully in the affirmative. If they do, this should be regarded as a big tick in an investor’s due diligence process on the fund.

What if the answer is no?

It’s worth mentioning that there’s no legal obligation in Australia for fund managers to disclose their skin in the game information to investors.

It’s also worth highlighting that plenty of funds have outperformed without the fund manager involved having skin in the game (and conversely, many funds have underperformed despite the manager involved having skin in the game).

However, the important takeaway for investors to be aware of is that skin in the game helps ensure fund managers’ degree of care, risk management, and conviction levels are aligned with investors. It’s this genuine alignment of interests which makes skin in the game such a valuable box for investors to tick when assessing fund managers.

If you don’t ask, you don’t get

So there you have it… the most important question to ask prospective fund managers could well be whether they have skin in the game.

Hopefully, the more individual investors ask this question, the more this information will be openly disclosed as the fund management industry learns to live by the same standards as the listed corporate world they’re investing in.

Disclaimer: This article is prepared by Simon Turner. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.