Look for Fund Managers Who Eat Their Own Cooking

The more a manager has personally invested in the fund he or she manages, the better it’s likely to perform.

By + More

There's an old saying that no one ever washed a rental car. That's probably not literally true, but it's true enough to make a salient point: that the care with which you treat something depends a lot on whether you own it.

The same seems to be true for the people who manage your money. The more a fund manager has personally invested in the portfolio he or she manages, the better it's likely to perform. That's become easier to demonstrate since 2005, when the Securities and Exchange Commission started requiring managers to disclose their own stakes in the funds they run.

That SEC data produced some striking numbers. For starters, as Morningstar reported in 2010, some 45 percent of core U.S. equity funds and 66 percent of core bond funds showed no manager ownership. The non-ownership figures were higher for fixed-income funds—up to 78 percent for municipal-bond funds.

Measured by assets, things look a little more palatable. Only 23 percent of core-stock assets were in funds with no manager ownership, and 47 percent were in funds where at least one manager had $1 million invested. Only 33 percent of core bond-fund assets were in funds with no manager ownership, and 30 percent were in funds with at least $1 million of manager ownership.

[Read: Why Do Smart People Make Bad Investments?]

To be sure, there are good reasons in some cases for fund managers not to eat their own cooking. If you run a state-specific municipal bond fund and don't live in that state (meaning you don't get the tax benefit), you probably wouldn't own the fund. Managers who are not U.S. citizens may be barred by their own national laws from investing in U.S. funds. Particular target-date funds may not be appropriate for the people who manage them, and manager incentives may matter little to the performance of index funds.

But where incentives do matter, ownership seems to matter, too. A 2006 study by Wake Forest University professor Allison Evans shows that funds run by managers who own at least $100,000 of the funds they manage generate returns that exceed what Evans calls "minimally invested" managers (of similarly styled funds) by about 2.6 percentage points.

Evans says it's fair to assume that the disparity in performance continues up the value chain. "Generally speaking … the higher the ownership, the bigger the difference," she says. "It's a little a harder to draw a conclusion on the upper end than on the lower end, where it's easy to see, if you're not invested at all, what the difference is."

Morningstar has also found correlation between manager ownership and performance. Using its star rating system—which ranks funds by risk-adjusted returns net of expenses (the highest receive five stars)—Morningstar assigns an average of 2.93 stars to core equity funds with no manager ownership, and 3.5 stars to funds where management owns more than $1 million. The difference in core bond funds is less striking but still observable: 3.2 stars for zero ownership, and 3.9 for ownership exceeding $1 million.

[Read: 5 Investing Themes To Focus On]

There are other benefits to manager ownership, according to Morningstar. For one, greater manager ownership correlates with longer manager tenure. Tenure at core stock funds with no manager ownership averages 4.7 years, compared with 12.1 years for those whose managers own at least $1 million.

Manager stakes appear to affect turnover, too. Evans found that funds with negligible manager ownership generate about 60 percent more turnover than those whose managers own more than $100,000. Higher turnover usually means higher expense ratios, at least for equity funds. One reason for higher turnover, according to Evans and other scholars, is that active managers are incentivized to look, well, active.

"Let's say you walk by someone's office and they're sitting there doing nothing. You're going to assume that they're not doing everything they're supposed to do," says Evans. "It may be that the optimal strategy for a mutual fund is not to trade anything; maybe things are going well as they are. But if people see me not trading and think I'm somehow shirking responsibility, then I might be incentivized to trade just to look like I'm an active trader."