Why Directors Should Have ‘Skin in the Game’

A study confirms “skin in the game” thesis.

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Mutual funds whose directors have "skin in the game" significantly outperform their competitors, according to a study by Syracuse University Prof. David Weinbaum. His results confirm the commonly held belief that directors who are invested in the funds that they oversee act as better stewards than directors who don't have any money on the line.

[See Study Shows Increases in Mutual Fund Fees.]

In the study, which was published last month in the Journal of Financial and Quantitative Analysis, Weinbaum and his colleagues examine roughly 1,000 actively managed stock funds from the 25 largest fund providers. They break the funds into four groups based on the amount of ownership interest that their directors have. The funds in the bottom quartile don't have any directors with money in them, while those in the top group are marked by significant director investment. All told, the funds in the top quartile have outperformed those in the bottom one by upwards of 2 percent per year.

"The most striking finding is that the funds in which directors own nothing—essentially, the funds in which no director has any ownership—underperform substantially. And there are many such funds, and they're just poorly governed funds, and it translates into very bad performance," says Weinbaum.

Interestingly, the biggest jump in performance came between the bottom and the next-to-bottom quartiles. In other words, funds that have even a few directors who are marginally invested tend to do noticeably better than funds in which directors don't own any shares. Meanwhile, there appears to be relatively little difference between funds in which the directors have small investments and those in which they have much larger stakes. The controlling factor, then, is whether directors have money in their funds rather than the extent to which they are invested.

The reasons behind the "skin in the game" thesis aren't hard to surmise. When directors have their own money on the line, they are more likely to view the issues before them from a shareholder's perspective. Also, directors set funds' expense ratios, so when they are invested, they actually have to pay the fees that they decide on. Not surprisingly, the study found that funds whose directors owned shares tended to have lower expense ratios.

"Fees are part of the story," says Weinbaum. "If you look at those funds in which directors don't own anything, they also charge higher fees."