Should Managers Invest in Their Own Mutual Funds?

It can benefit both investors and mutual fund managers when managers ‘eat their own cooking.’

Business team working hard together
By + More

Investors consider a number of factors when they're hunting for the right mutual fund, from the size of the fund to the experience of its managers. One question investors rarely ask, however, is, "Does my portfolio manager invest in his or her own fund?" They should, experts say.

After all, department stores ask their employees to dress in the brand's clothes for a reason, and we all know the adage "Never trust a skinny cook." Why shouldn't the same principle hold true for mutual fund managers?

In 2011, Morningstar found a correlation between portfolio managers' investment in their funds and fund performance, although Russel Kinnel, Morningstar's head of mutual fund research, says there is not necessarily causation. Still, there are cases where it's probably a good sign that your mutual fund manager invests in his or her own fund.

[See: The 10 Strangest Mutual Funds.]

If you are looking for managers who will own the fund alongside their investors, be sure they actually hold more than a token amount, Kinnel says.

"There are hundreds of funds where a manager has millions invested, but there are thousands of funds where they don't invest anything, so it's easy to spot those [$1-million-plus invested] funds," Kinnel says. He notes that firms with more managers who invest in their own funds tend to have a longer-term culture, which is ultimately beneficial for retail investors.

Portfolio managers who don't invest in their funds have few excuses, he says. "I'll hear people say, 'I don't want to invest in funds because I live in New York [where taxes are high] and that's expensive,' but some of these guys are collecting bonuses in the $12 million range," Kinnel says.

Kinnel says it is ultimately better for long-term investors to find funds in which the manager invests rather than funds managed by a firm that ties short-term fund performance to manager compensation. Funds managed by firms that tie compensation to three-to-five-year performance are much better bets if you're looking for a fund that practices those incentives.

"Shorter-term incentives make managers feel compelled to chase whatever does well this year, and that is a recipe for mediocre performance in the long term," Kinnel says.

Russell Croft, president and portfolio manager at Croft Leominster, agrees with the idea that managers should invest a substantial amount of their money in the fund they run. Croft says it's a good practice to invest at least 25 percent of your investment portfolio in the fund you manage. How much managers should invest in the fund also depends on the manager's age and how much money they want to have in stocks versus bonds, because the fund may not be the perfect fit, Croft cautions.

[Read: 7 Reasons to Consider Dumping a Mutual Fund.]

Kinnel agrees with Croft's contention that there are a few exceptions to the rule when it comes to what you should expect your fund manager to invest in his or her fund. For example, Kinnel says managers have a better excuse not to invest in target-date funds, single-state municipal bond funds and index funds. A manager may run 10 different index or target-date funds, making the expectation that he or she would invest in all of them unrealistic. For a single-state municipal bond fund, for example, it doesn't follow that a Boston-based manager would own a California or New York fund because said manager doesn't receive the tax benefit, Kinnel points out.

From a portfolio manager's perspective, however, it only benefits a manager to invest in his or her own fund, Croft says.

"We manage money for the long term, so why wouldn't we be investing in our own funds? Why not put our money where our mouth is? It's a good talking point with advisors, so they know we have skin in the game. It resonates," he says.

It's tough to get a full picture of how much mutual fund managers invest in their funds, however, because data is limited. Morningstar can only obtain ranges of what managers invest, not exact dollar amounts. But among managers at funds of all sizes who do make the decision to invest hefty personal sums in their funds, a few trends are discernible.

Fund Managers with $1M or More Invested in Their Fund
Percentage of Fund Managers With $1MM+ # of Managers with $1M+ in Fund # of Current Managers % of Managers with $1M+ in Fund
American Funds 61 319 19.12
Franklin Templeton Investment Funds 26 339 7.67
Vanguard 21 303 6.93
Fidelity Investments 48 849 5.65
Columbia 15 296 5.07
Legg Mason 11 287 3.83
JPMorgan 11 360 3.06
John Hancock 7 343 2.04
AllianceBernstein 3 288 1.04
American Century Investments 1 317 0.32
Source: © 2013 Morningstar, Inc.

U.S. News obtained data from Morningstar on funds where managers invest more than $1 million in their fund. Many small fund firms such as Absolute Strategies, GoodHaven and Schneider Funds had only two managers, with both investing more than $1 million in the fund. For bigger firms (those with 287 current managers or more), American Funds won out, with 19 percent of its 319 fund managers investing more than $1 million in their fund. Franklin Templeton Investments came in second with 7.67 percent, and Vanguard came in third with 6.93 percent. What does this tell investors? The bigger fund firms tend to have less skin in the game.

[Read: Mutual Funds Swapping Managers at Alarming Rate.]

Some midsize firms (those with 50 to 287 managers) have a higher percentage of managers with sizeable investments. The top 10 midsize firms with the most managers investing more than $1 million were Dodge & Cox with 60 percent, Royce with 32.9 percent and Janus with 22 percent. TCW, Pimco, Neuberger Berman, Calamos, Manager Funds, Aston and William Blair also made it in the top 10 firms with the highest percentage of $1 million-plus invested.

Corrected on 11/11/2013: A previous version of this story misstated the number of funds with managers who don’t invest in them, and the amount in bonuses managers are collecting.