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Contributors: Douglas McIntyre Jon C. Ogg

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Thursday, September 14, 2006

Mutual Fund Performance and Portfolio Manager Ownership

From Value Discipline

The idea of aligning management interests with that of shareholders has been around for a long time. Stock option programs and restricted stock programs were designed (at least originally) to attempt to symmetrize the position of corporate management with that of shareholders. Needless to say, history has shown that stock option programs per se have generally done little more than aggrandized the wealth of the “front row” at the expense of shareholders. Some companies require executives to maintain a minimum ownership in the equity of the business. An example of this in the U.S. is The Gap Inc (GPS) which describes its ownership requirements as : “The Gap Inc. ("Company") Board of Directors believes that Company executives should have a meaningful ownership stake in the Company to underscore the importance of linking executive and shareholder interests, and to encourage a long-term perspective in managing the enterprise.” Other firms have enhanced their corporate governance to require even higher ownership levels based on executive compensation. A great example is the requirements of the Royal Bank of Canada which now requires its CEO to own a minimum of seven times his average base salary. In addition, corporate directors at RY are required to hold a minimum of $500,000 of stock.

The notion of “eating one’s own cooking” as Buffett describes it has been a factor for selecting securities for some time. As Buffett describes it in his Berkshire “Owner’s Manual”:

“Charlie and I cannot promise you results. But we can guarantee that your financial fortunes will move in lockstep with ours for whatever period of time you elect to be our partner. We have no interest in large salaries or options or other means of gaining an “edge” over you. We want to make money only when our partners do and in exactly the same proportion. Moreover, when I do something dumb, I want you to be able to derive some solace from the fact that my financial suffering is proportional to yours.”

Does this principle apply to mutual fund performance?

Since March of last year, managers of U.S. mutual funds have had to disclose how much they actually have tied up in the funds that they manage.The S.E.C. has stated that,” A portfolio manager’s ownership in a fund provides a direct indication of his or her alignment with the interests of shareholders in that fund.” A recent study by Khorana of Georgia Institute of Technology, Servaes of the London Business School, and Wedge of The University of South Florida has just examined whether higher ownership is linked to performance.

Since the requirements are so new, the statistics represent a very small slice of time, but nonetheless I think are interesting. To quote the study:

While 57% of portfolio managers do not own any stake in the funds they manage, using the most conservative estimates, the average manager has a stake of $97,000 with the 90th percentile of the distribution being $160,000. The average ownership represents 0.04% of assets under management; the 90th percentile is 0.09%.Ownership levels are highest in domestic equity funds, with an average ownership of about $155,000, and a 90th percentile of $510,000. These amounts represent 0.05% and 0.15% of assets under management, respectively. Even though these stakes are modest, we find that they are sufficiently large to affect excess fund performance in 2005.

To my knowledge, very few funds actually mandate that the manager own some of the fund. The Davis Funds, a group I admire for their discipline, has a very unique commitment to their mutual fund family: “As of December 31, 2005, the Davis family, employees and directors have more than $2 billion of their own money invested side by side with shareholders in the various mutual funds managed by the firm. We remain the largest group of shareholders in our investment products, which ensures that our interests are closely aligned with those of our clients.”

It should come as no great surprise that increased ownership in the fund improves the incentives of managers to generate superior returns. The extent of the outperformance is quite surprising.The survey included 1406 funds of all sorts ranging from domestic US equity to balanced, bond, and international funds.The extent of the outperformance is significant.

In the 581 funds where there was management ownership, the mean return was 8.7% and the median was 6.39% as compared to the no-ownership funds with 6.2% and 3.99% respectively.

When measured against the return of the median fund in the matched investment objective (balanced versus median balanced, sector versus sector) what the study called the objective-adjusted return, the owned funds beat the objective with a mean of 1.44% and median of 0.21% as contrasted with the non-owned funds 0.29% and -0.2%.

When risk-adjusted as measured by alpha, similar results were found. Owned funds generated a mean alpha of 1.88 and a median of 0.45 as contrasted with non-owned of 0.59 and =0.21 respectively.

Ownership matters and eating your own cooking is important.This information should be more readily accessible and transparent than current practice.

Learn how your investment manager is compensated. In a study done in 2004, the minimal ties of portfolio manager performance to what the clients received were examined. This study, by Farnsworth and Taylor, at the Washington University School of Business observed:

“The survey indicates that over 45 percent of a portfolio manager's compensation is due to their bonus. More than 44 percent of the money managers responding to the survey said their firm's overall profits have the largest impact on their bonus, greater than any other incentive, including their client's investment performance. Tax efficiency and risk control were ranked as the lowest incentive by the portfolio managers."

Clearly, risk control and tax efficiency should be important attributes for your investments. It appears that one of the best ways of ensuring this is to know that your investment manager is lined up with you!

Disclaimer: I, my family, and some clients have a current position in Berkshire Hathaway.

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