Mutual Fund Managers Don’t Invest in Their Own Funds!
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. An Update to a Shocking Morningstar Report
2. What’s The Big Deal?
3. What Do They Know That You Don’t Know?
4. Other Important Questions To Ask
It’s not always easy admitting when you’re wrong, but it’s something I have to do in this week’s E-Letter. Back in June of 2008, I wrote an E-Letter highlighting a report that Morningstar had just released showing that many mutual fund managers did not invest in their own funds. In the Conclusions section of that E-Letter, I said the following:
I suspect that the publication of this report will cause many fund managers to invest in their own funds, but for the wrong reason. I’d rather have a manager invest because he has confidence in his or her own abilities, rather than just to get off of Morningstar’s list.
Imagine my surprise when I read an article in Investment News about Morningstar’s most recent update of that study and learned that not only had managers’ investment in their own funds not improved, but had actually gotten worse! My prediction that the Morningstar study would embarrass money managers and cause them to pony up some of their own money was wrong. Instead, it seems that other mutual fund managers, learning of the widespread lack of manager investment, decided to follow suit.
While there is certainly no legal requirement that mutual fund managers invest in their own funds, I think investors have a right to expect money managers to be invested right alongside them. I certainly do! I think this is especially true in light of some of the black eyes Wall Street has been given over the last year or so.
This week, I’m going to highlight the disappointing numbers in the recently released Morningstar update. While the numbers may shock you, it’s probably no surprise considering what has transpired in the financial markets since my June 2008 article. Still, I think it’s very important that your money manager be invested alongside you, with his/her own money on the line – and not just a token investment.
After that, I’m going to again discuss other information that you may not know about money managers unless you ask the right questions. These questions are among the many we routinely ask as part of our “due diligence” process when evaluating money managers. I think you’ll find them useful as well as informative. Feel free to forward this E-Letter to anyone you think may benefit from this information.
The Latest Morningstar Study
Accessing manager investment information is not difficult. As a general rule, you can find it in the fund’s “Statement of Additional Information” (SAI), which is usually available either in printed form accompanying a fund’s prospectus or on a fund’s website. If you can’t locate the information in either of these two places, ask the fund’s sponsor to provide it to you.
I would think most investors assume that their mutual fund manager has a sizable amount of his/her own money in the fund(s) they manage. I certainly do; in fact, I have the bulk of my non-cash assets invested in the products I recommend. Yet the Morningstar studies show that over half of the mutual fund managers they track have NONE of their own money in the funds they manage. ZERO.
Before delving into the most recent numbers, let me go back and revisit the findings from the 2008 Morningstar study. In its initial report, Morningstar found that 47% of the mutual funds it tracked for ownership levels had no manager investment. In the most recent report, this percentage has increased to 51%. So, while mutual fund advertising and brokers counsel investors to “stay the course,” the managers of these mutual funds have been heading for the exits. If that’s not an indictment of buy-and-hold strategies, I don’t know what is.
More telling, however, is the relative performance of funds with and without manager investment. According to the Investment News article, funds with manager ownership delivered better performance than those without. Based on Morningstar’s research, funds whose managers had investments of $1 million or more in the funds they managed outperformed 58% of their peers over the five-year period ending in July 2009.
Morningstar representatives stopped short of saying that manager ownership levels can help predict future performance levels but the data so far indicate that there is at least some relationship between the two. Additional time periods will need to be analyzed before any predictive relationship can be established, if it exists at all.
While Morningstar is quick to point out that the lack of a manager’s investment does not necessarily doom a fund to poor performance, it certainly doesn’t do anything to help an investor’s confidence in the fund. I think this is especially true in light of recent shenanigans in the financial services industry such as last year’s subprime crisis and the mutual fund scandals back in 2003. Sadly, I think it shows a sense of arrogance on the part of many mutual fund insiders that they expect investors to put money into funds that they won’t even invest in themselves.
The Importance of Personal Investment
Some in the investment world and financial press were shocked at the revelations of these Morningstar studies, but not me. After evaluating money managers for over 30 years, it’s hard to be shocked by anything I might uncover. It has not been uncommon for me to come across professional money managers who do not invest in their own programs. Fortunately, I can also attest to the fact that there are many money managers who do put their clients first and do invest alongside them in the funds and programs they manage.
As noted above, I invest my own money in all of the programs my company recommends, which I feel is important. You should also know that I require the money managers that we recommend to “eat their own cooking.” The way I see it, if a money manager’s program isn’t good enough for his/her own money, then it’s certainly not good enough for you or me.
Simply put, if I am going to entrust my clients’ money, and my own money, to an Advisor, I want to know they have a significant percentage of their own money in their programs. If an Advisor doesn’t have his own money in his program, I consider that to be a major red flag.
Interestingly, most of the successful Advisors I have met do have a huge amount of their own money invested in their programs – sometimes even more than they should for purposes of diversification. When you read over some of the bios of our recommended Advisors, you will find that several of them got into the money management business primarily to manage their own money after retiring from another profession or selling a business.
Upon receiving large payouts, they could not find acceptable money managers for their nest eggs, so they decided to do it themselves. Thus, most of the managers I recommend only started managing money for outside investors after they devised a successful system for managing their own money.
On a more basic level, having both the Advisor and myself investing significant portions of our net worth alongside our clients shows our confidence in the programs we offer. The last question I always ask myself when considering a new Advisor is whether I want to invest my own money in his or her program. If the answer is yes, then we move ahead. If not, then you’ll never see that program on our list of recommended Advisors.
What Do They Know That You Don’t Know?
To be fair, there are a few legitimate excuses for fund managers not to invest in their own funds. These might include “index” funds, “target-date” funds that do not meet the manager’s time horizon, single-state municipal bond funds where the fund manager lives in another state and situations where the manager is a foreign national from a country that bars investment in US funds.
Those possible exceptions aside, I find it hard to imagine a mutual fund objective that couldn’t merit at least a small allocation of the fund manager’s own money, many of whom earn millions of dollars per year in management fees.
While the Morningstar studies do not venture a guess as to why most managers don’t invest in their own funds, I suspect that at least one reason is that they are “closet indexers.” This term has been around for a long time, but really came into common use back in the late 1990s. In essence, a closet indexer is a mutual fund manager that claims to actively manage a fund’s stock portfolio, but actually emulates a passive benchmark index such as the Dow or S&P 500 Index.
Since most mutual funds are evaluated by how their performance compares to a benchmark stock or bond index, some managers figure it’s safer to simply try to match the index rather than taking a chance and significantly underperforming the benchmark. And getting down to brass tacks, mutual fund managers are often compensated based on their performance relative to the benchmark, rather than their absolute performance.
So how does closet indexing relate to managers investing in their own funds? Simple, most closet indexers are in funds that claim to be actively managed and charge higher fees for doing so. However, if the manager knows that the performance will simply track the index, why not invest his or her own money in a low-cost index mutual fund?
If nothing else, the events on Wall Street over the last couple of years have shown us that financial executives and money managers are not above putting their own self interests above those of their clients. Is this true in every case where fund managers don’t invest in their own funds? No, but it certainly dictates that additional investigation be done to discover the reason they don’t want to eat their own cooking.
Other Questions To Ask
It is a mistake to assume that money managers, or mutual funds for that matter, will provide you all of their pertinent information voluntarily, especially if some of that information is negative. You have to know how to dig for the pertinent information, how to ask the right questions and press until you get the real answers. While performance databases such as Morningstar make it easy to crunch numbers, there are other important facts you can only learn by knowing to ask the right questions.
Below, I have listed a number of questions we ask as part of our due diligence process for money managers. Please note that these comments relate mostly to independent professional money managers, but the principles can be used for virtually any type of investment offering. Here are some of the questions you should ask before hiring a money manager:
1. Is The Performance Record For Real?
Assuming the Investment Advisor you are considering actually manages money, the firm will have a performance record of some sort. The first thing to determine is whether the performance is actual, or is “back-tested” or a combination of the two. Back-tested numbers are usually derived by applying a trading model to historical market data. Obviously, an actual track record (that really happened with real money) is preferable to anything back-tested (a simulation that didn’t really happen with real money).
We don’t put much faith in back-testing because it’s a process whereby an Advisor takes its actual strategy and resulting recommendations and applies those signals to past market data before it began to manage real money in real market conditions. The obvious weakness to most back-testing is that it implies that future results will be similar to the past.
In over 30 years, I have never seen a back-tested track record that didn’t look outstanding. Why? Who would advertise a bad one? No one. Yet very few back-tested track records actually succeed in real time. In fact, I’ve never seen even one investment program match its back-tested results.
BOTTOM LINE: NOTHING BEATS ACTUAL PERFORMANCE.
Unfortunately, you still have to be careful even if a money manager offers you an actual track record. That’s because some aspiring money managers will simply make up a completely bogus actual or hypothetical performance record and try to pass it off as real. While we’d like to think that such fraud would be easily caught, remember that Bernie Madoff got away with fabricating performance numbers for years, and many of his clientele were among the richest and most sophisticated investors around.
Since most Registered Investment Advisors (RIAs) are not subject to the rigid performance reporting criteria applicable to mutual funds, a careful review of the performance numbers given by the Advisor is absolutely critical. In recent years, many successful RIAs have already taken that step and spent money to have their performance record audited periodically by independent accounting firms.
Where an independent audit is not available, there are other alternatives. One such resource is the CFA Institute, which has developed a set of standardized performance reporting guidelines known as the Global Investment Performance Standards (GIPS). Advisors whose performance is “GIPS compliant” can represent that they adhere to the high ethical standards for creating performance information that ensure fair and accurate representation as well as full disclosure. Over the years, GIPS compliant performance reporting has become an industry standard.
If neither GIPS nor audited performance numbers are available, you can also ask to see copies of mutual fund or brokerage statements that support the track record. Most money managers keep a test or “model” account open, so ask to see copies of the brokerage statements for that account. If no test account exists, ask to see copies of a long-term client who has not made additions or withdrawals since first investing. Of course, any personal information would be deleted.
It is important to note that individual investors may find it difficult or impossible to get this kind of information from an Advisor. While Advisors regularly provide such detailed information to another RIA like my company, which represents lots of individual investors, many are hesitant to make detailed client information available to a single prospective client, unless it is a very large investment.
One last point on performance is in regard to “hypothetical” numbers. While this may sound the same as back-tested performance, it’s not always the case. Some hypothetical performance records are made up of the actual track records of mutual funds or money managers combined into a single portfolio. In these cases, the performance is real but the combination is hypothetical, since the portfolio of investments did not really exist in the past.
2. What Is The Money Manager’s “Methodology?”
Once you have verified that the performance advertised by the Advisor is for real, the next step is to understand generally how the Advisor’s investment system works. There are many different types of investing strategies and trading systems. Some are fundamentally based; some are technically based; some are discretionary; and many are a combination of these approaches. Likewise, the use of computers and software varies widely.
Most successful money managers have a well-developed “methodology” that drives their systems. While successful Advisors tend to protect their “secrets” to success (ie – certain information is proprietary), they should be willing to explain generally to you how their systems work. Plus, it never hurts to sign a confidentiality agreement to put the Advisor more at ease.
If the Advisor cannot explain to us generally how the system works, that raises several questions for us: 1) Is there really a methodology and a system at all, or does the Advisor simply trade “by the seat of his pants?”; 2) Is the system so complicated that maybe even the Advisor himself doesn’t fully understand it?; or 3) Is the trading signal actually produced by someone else and simply given to the Advisor over the phone or the Internet?
Over the years, we have run into all of these issues when performing due diligence on professional money managers. Needless to say, we don’t recommend any Advisors who fall into any one of the above categories. It is sometimes a difficult process to determine whether an Advisor has real skill, or has just been lucky enough to produce a good track record. By developing a general understanding of how the Advisor’s system works, investors can better evaluate its performance.
3. Is There A Strong “Back-Office” To Handle Administrative Issues?
Successful Advisors must have a good performance record – that’s a given. But that’s just where it starts. Once an Advisor generates a signal to buy or sell, the administrative staff must be sufficient to implement the trades, see that they are executed properly and make sure they are allocated in the correct amounts to all the Advisor’s various clients. This operation is commonly referred to as the “back-office.” In addition to the back-office, there must be adequate administrative staff to be able to interface with clients and firms, like my company, that recommend the Advisor’s investment programs.
The best way to determine the sufficiency of the back-office operation is to conduct an on-site visit to the Advisor’s offices. In such visits, we review many facets of the administrative side of the business. This includes everything from how the system works, to trade execution, to account allocation, to client statement generation, and many other elements of the business.
In particular, it is important to determine that the Advisor’s staff is equipped to handle not only the current assets under management, but even more. Remember, if an money management firm continues to be successful, it will almost certainly accumulate a larger number of accounts and more assets under management. Ideally, the Advisor will have a long-term growth plan for adding administrative personnel at successive levels of increased assets under management. We also like to see that the Advisor has a serious commitment to the latest computer hardware, software, technology and the personnel to run it.
This is not to say that an Advisor must have a large number of employees to be considered successful. Many Advisors have outsourced administrative tasks to independent custodians such as trust companies, brokerage firms, mutual fund families and even other Investment Advisors. Again, the on-site due diligence review helps to confirm that these resources, coupled with the Advisor’s internal staff, can handle significant growth in assets under management that we or others may bring about.
The on-site visit has another beneficial outcome. It allows us to meet and talk with all of the principals and staff, and get a good feel for the organization as a whole. I maintain that there is nothing better than meeting an Advisor and his/her staff face-to-face in their offices. This is a very expensive effort (in our case we always send at least two people) but one that is well worth it! Unfortunately, this is not always possible for individual investors to do on their own.
4. Are There Any Regulatory Skeletons In The Closet?
Most professional money managers we evaluate are either registered with the Securities & Exchange Commission as Registered Investment Advisors, or with their state securities board. The regulatory agencies have strict rules that must be followed in order to avoid regulatory problems. Not all firms are compliant. You want a money manager that is serious about compliance with all applicable rules and regulations.
Appropriate due diligence requires that the regulatory history of the Advisor be examined to see if there have been any significant compliance problems in the past. Key personnel of the Advisor should be checked out as well. This is accomplished through a review of required disclosure information, a search of the SEC or state regulatory database, background checks and a review of any reports from on-site SEC examinations.
It is important to realize that many Advisors also have affiliated companies that may be registered under other regulatory bodies such as the Financial Industry Regulatory Authority (FINRA), National Futures Association (NFA), etc. The due diligence process should include a review of the regulatory histories of all such related entities. Here, too, this is not always possible for individual investors to do on their own.
In addition to regulatory background checks, the principal traders should also be questioned about any significant personal situations that may have occurred in the recent past. An Advisor’s performance can be affected by a significant personal event, such as the death of a loved one, marriage, divorce or geographical move. All of these factors are also taken into consideration while doing a background check on the Advisor.
Finally, a regulatory review should also make sure that the Advisor has taken steps to comply with all regulatory requirements. Since compliance issues are designed to protect individual investors, we consider them to be very important, both at our firm and at any Advisor we may recommend. While we can’t evaluate the validity of any steps the Advisor has taken, we can determine if an effort has been made to be compliant.
5. Does The Manager Have A Backup Plan In Case Of Emergency?
Ideally, an Advisor will have a back-up plan in case of emergency. This could mean anything from a medical emergency or death, to an extended vacation, or even a power outage or disruption of Internet service. We want to see that trading can continue and that client accounts will continue to be serviced.
Even if an Advisor has a sufficient administrative staff or has outsourced back-office operations, this is no guarantee that someone could trade effectively in the absence of one or more of the Advisor’s principals. The optimum situation is that the Advisor has at least one or more individuals who are familiar with the trading system and can continue the investment programs in the absence of the primary trader.
As a bare minimum, an Advisor should have someone designated who could unwind existing trades and take the program to cash, especially in the situation where the Advisor has died or become incapacitated or will have to be out of the office for an extended period of time. This gives investors more assurance that their accounts will not be locked into a trade during unfavorable market conditions because of the Advisor’s absence.
In the wake of 9/11 and hurricane Katrina, the SEC has stepped up its requirements that Advisors have Business Continuation Plans. A review of this plan is an important part of all due diligence reviews that we perform, and it should be on your list of questions to ask as well.
While the Investment News article predicts that manager ownership patterns will change as more attention is paid to the issue, I’m not going to go out on a limb this time. Until mutual fund investors stop chasing “hot” performance and start digging down into the other important features and disclosures, mutual fund managers will likely continue to have the attitude of “invest as I say and not as I do.”
Though the issue of whether or not money managers invest in their own programs is important, it’s not the only issue that needs to be addressed when evaluating professional money managers. The additional due diligence considerations I discussed above should give you a pretty good idea of what it takes to evaluate mutual fund managers, RIAs, managed account Advisors and hedge fund managers. Now all you have to do is apply these principles to the various investment alternatives you may be considering.
Unfortunately, most investors never take the time to ask even a fraction of the questions necessary to get the information discussed in this article. Most also have no desire to travel all over the country and conduct this type of intense due diligence. Even if they did, most investors are not equipped to evaluate the answers given to many of the questions discussed above or the operations of funds and Advisors.
The good news is that my company already has the staff, expertise, experience and the annual budget necessary to search for successful money managers and engage in the due diligence process on behalf of our clients. We also have the necessary hardware, software and database applications to be able to monitor performance on a daily basis as well as identify new prospective Advisors.
If you are interested in the programs I recommend, give one of our Investment Consultants a call at 800-348-3601. You may also contact us via e-mail at firstname.lastname@example.org. You can also visit our website at www.halbertwealth.com to learn about the kinds of investment programs we offer.
In closing, I would like to wish you all a very Happy Thanksgiving! I have so much to be thankful for: a wonderful wife, best friend and business partner; two kids who are surpassing all my hopes and dreams for them; thousands of loyal clients and readers all across America; and a wonderful staff that feels more like family than co-workers, just to name a few. God has been very good to me.
Wishing you a happy turkey day,
Gary D. Halbert
George Washington’s View on Thanksgiving
Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.