Investing

Check this critical data point before buying a mutual fund

When buying mutual funds, among the best predictors of success is a management team that invests in its own strategy.

Twenty/20

Imagine you're at a dinner party with friends. The host brings out a beautiful lasagna and everyone takes turns cutting themselves a piece. But when it gets back to the host, he or she says, "No thanks, I'll stick with the salad." No matter how good your food looks and smells, you'd have to start wondering what exactly is under that layer of melty cheese.   

You get suspicious of a chef that doesn't eat his or her own cooking, right? And if you're an investor, you should likely be wary of a mutual fund manager who doesn't invest in his or her own strategy. Which makes the following tidbit, tweeted by Morningstar director of manager research Russ Kinnel, a little surprising: "There are 1155 mutual funds where at least one manager has invested more than $1M of their own money. There are 5185 funds where managers have 0 invested."

Given that there are about 8,000 U.S.-based mutual funds, that means about 65% of portfolios are run by managers who aren't buying what they're selling.

If you're considering adding a mutual fund to your portfolio, you shouldn't necessarily exclude a fund if the managers don't have skin in the game. But it should be an important factor in your decision-making process.

Don't invest in a fund without checking this data point

Mutual fund managers must disclose the amount of their investment in the portfolio in the fund's filings with the Securities and Exchange Commission. Rather than listing the actual dollar figure, the investment amount is reported in ranges: none, $1 to $10,000, $10,000 to $50,000, $50,000 to $100,000, $100,000 to $500,000, $500,000 to $1 million, and $1 million-plus.

If you don't want to sift through SEC filings, search the fund on Morningstar.com and head to the fund's "People" tab. A bar indicating the level of investment in the fund is highlighted in blue under each portfolio manager's name.

There are three types of mutual funds for which this data isn't particularly important, Kinnel says:

  • Index funds are safe to ignore. Managers of such portfolios aren't making decisions that impact the investing strategy, and they aren't paid as much as managers who are.
  • Managers who steer funds that invest in foreign stocks and who live abroad (in the country where they're investing, for instance) may not be allowed to invest in U.S.-based mutual funds, Kinnel points out.
  • Managers who invest in a particular state's municipal bonds, which come with tax breaks for residents of that state, may deserve a pass, too. If they manage several such strategies, they may not live in the state where you're considering investing, Kinnel says.

Funds run by managers who invest more outperform peers

For mutual funds meant to be used as core portfolio holdings — think ones that invest in large swaths of the stock market, like large-, midsize-, or small-company U.S. stock funds — look for manager investment of over $1 million, Kinnel says.

"A manager at a big fund at a decent firm is probably making eight figures. A million invested in the fund doesn't seem like too much," he says. Managers of more niche funds, such as, say, an emerging markets stock fund, should have somewhere in the range of $500,000 invested, he says.

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Part of the appeal is peace of mind, says Sam Huszczo, a certified financial planner and founder of SGH Wealth Management in Southfield, Michigan. Fund managers, like all of us, have egos, he says. They may be tempted, if they're not invested, to make moves to bolster the short-term performance of their fund.

"If a downturn in the market forces a manager into a difficult decision, I want to be sure that he or she is acting in the best interest of the long-term investor," he says.

As with all things related to investing, the proof is in the performance. Tracking long-term returns tied to manager investment in funds is difficult because managers don't report exact dollar amounts and because the amount a manager invests can change over time. But in a 2015 study, Morningstar found that funds run by managers with more than $1 million invested consistently outperformed peer funds in which managers invested less.

"Whenever I've tested this, it's been the best predictive data point for outperformance — right behind fees," Kinnel says.

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