Skin in the Game

I confess to having been deeply sceptical when I read an appeal last week by a boss of a fund management firm (Schnider,Walter & Kollegen)  to make it an obligation for fund managers to invest personally in the funds they manage. For Mr Walter, the notion that having some ‘skin in the game’ makes for better investment decision-making is so self-evident it barely needs defending. Nevertheless, the article cites a Morningstar study from 2010 that revealed above-average performances among funds where the manager held a personal stake.  For many, it feels intuitively correct to oblige fund managers to ‘eat their own cooking’ in order to ensure their interests are aligned with those who entrust them with their money. However, is personal investment by the fund’s management one of those solutions to a complex problem that Einstein[1]  so liked to criticise: the one that is clear, simple, and wrong?

To start with, there are numerous examples of disastrous decision-making by people who were personally invested. Take Lehman Brothers, the investment bank driven to bankruptcy by a CEO, Richard Fuld, who held 10.9 million shares. Indeed, the company was very widely- owned by its employees. Executives, directors and rank-and-file owned a quarter of the firm when it hit the wall in 2008, many of them falsely reassured by the knowledge the man at the top had skin-in-the-game. They lost over $10bn in that frightful year; Fuld lost $700m of his personal wealth. Yes, interests were aligned, but the outcome was not the one investors hoped for. It is not clear whether the superior fund performances claimed by Morningstar were because of the managers’ personal stake; the causality could have been in the opposite direction, or both observations could have been caused by an unknown third factor, for example, a specific corporate culture. Nor is it clear whether the researchers controlled for survivorship bias. In any case, the desirability of skin-in-the-game is not as self-evident as Walter claims.

I cannot get away from the thought that skin-in the-game is no more than a fast and frugal way to evaluate a fund or its manager without having to go to the trouble of doing a thorough due diligence. Instead of investigating the manager’s philosophy, methodology and discipline, skin-in-the-game advocates seem simply to want to have a rough-and-ready measure to determine whether the fund is good or not, a bit like ‘past performance’. If it ever becomes an obligation, a similar caveat will need to be attached: the fund manager’s personal stake is no guarantee of superior future returns.

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