Trusting your money with a fund manager is one of the biggest leaps of faith that investors ever make. Yet while there are plenty of ways that fund managers can take advantage of their customers for their own profit, looking for one particular thing from your fund managers can reassure you that they're really on your side.
Dealing with conflicts
Whenever you consider handing your money to someone else to manage, your first concern should be whether the manager you pick will do everything possible to earn you the highest returns possible. Unfortunately, not everyone has your best interests at heart. As victims of Bernie Madoff and other fraudulent professionals can attest, it's more than necessary to be extremely cautious whenever you invest.
But not all of the conflicts that fund managers can have are as obvious as a Ponzi scheme. Here are some examples:
management fees that are based solely on the amount of assets under management within the fund. Because the fund manager gets paid the same regardless of how well, or badly, the fund performs, such compensation schemes don't give managers a strong incentive to seek out extraordinary returns. Managers may have an incentive to take larger risks than you'd prefer since they know that generating extremely high returns will attract performance-chasing investors, and boost fund assets. If you're simply looking to eke out an extra percentage point or two of return from a mutual fund, this level of risk will contrast with your investment goals.Similarly, some funds, especially those that invest in markets with less liquidity -- such as small-cap stocks or convertible securities -- operate best below a certain level of assets. Yet closing a fund to new investors means turning down the opportunity to make more money -- a difficult choice for many fund companies to make.With all these potentials for conflict, how can you be sure your managers will work for you rather than against you? The best indicator is to see if fund managers have their own money at risk within the funds.
Do as I say and as I do
Think about it: Few things exude greater confidence about a fund's prospects than seeing the fund's own managers put their money where their mouths are. Just as investors see company leaders like Warren Buffett as having greater credibility because they have huge portions of their net worth locked up in the stock of the companies they run, so too can a large position in a fund give a fund manager a better reputation.
In fact, some preliminary research from Morningstar suggests that funds whose managers have their own money invested may perform better than those whose managers don't put their personal assets at risk. Disclosure of fund managers' holdings is a relatively recent requirement, having started in 2005, so drawing firm conclusions is premature -- but Morningstar believes it makes a difference and sees it as a common thread among many of the funds it recommends.
You can find many funds where managers own substantial positions in the fund. Here are just a few:
Fund
10-Year Annualized Return
Positions Held by Manager(s)
Holdings Include ...
Oakmark Select (OAKLX)
3.8%
More than $2 million
Discovery Communications (Nasdaq: DISCK), Best Buy (NYSE: BBY)
American Funds Washington Mutual Investors (AWSHX)
0.0% Continued... |