One of the things that infuriated investors in Neil Woodford’s disastrous income fund was that the former star investment manager carried on drawing huge fees even as the performance tanked. Because his main remuneration was related to the amount of assets in the fund rather than the performance, he continued to pull in millions in fees even as investors’ returns tumbled.
Woodford also had a holding in the fund, so he was sharing more directly in the pain being suffered by his investors. But the amount was never disclosed, so investors could not tell whether it was a trivial amount or serious money.
At the time of the Woodford collapse we argued that fund managers should be required to disclose how much of their own money was in their fund. So it is encouraging that Interactive Investor, the investment platform, has launched a campaign to persuade the Financial Conduct Authority to introduce just such a rule.
The standard fee structure for investment managers, linked to assets in the fund, sets up a host of bad incentives. Part of the problem is that investors have a much stronger inclination to buy a fund that has had good performance than dump one that has had bad.
So there is an incentive for managers to engineer good performance figures in the early days, even if that requires taking outsized risks, to suck in as much money as possible.
The bigger the fund gets the more difficult it is to outperform, but that does not matter so much for the manager because many investors will stick around through a long period of lacklustre performance. Once the fund has reached a certain size, the incentive for the manager is to play safe (though, sadly, this did not happen with Woodford).
Most firms are acutely aware of these bad incentives and have tried all sorts of ways to get around them. Unfortunately, end investors have not been enthusiastic about the obvious solution — linking fees to the performance of the fund, as happens in hedge funds and private equity.
Of course, firms do not have to incentivise portfolio managers in the same way that the firms themselves are incentivised. Most try to align pay with the interests of investors. But they cannot ignore their own economics not least because star managers like Woodford can always decide to leave and set up their own shops where they can pay themselves according to assets in their fund.
Terry Smith, one of the most successful fund managers of recent decades, argues that the best answer is for senior fund executives to have a large chunk of their wealth tied up in the funds their firm manages. Smith has said he has more than £250m of his own money in his funds. You would think that would concentrate his mind a bit.
Many investment firms encourage their portfolio managers to invest in their own funds and, on balance, the academic evidence suggests that this is good for investors. A study by Linlin Ma of Northeastern University in Boston in 2018 demonstrated that managers who had stakes in the funds they ran took lower risks.
But it is complicated. Obviously, having skin in the game does not ensure that the managers’ interests are aligned with outside investors. Just remember all the Wall Street bankers like Dick Fuld at Lehman Brothers who had huge stakes in the firms they ran. That did not stop them running the banks into the ground.
Much will depend on the individual circumstances of the executive. If a portfolio manager has a huge proportion of their wealth tied up in their fund that might make her more, rather than less, risk-averse than their outside investors would like.
This highlights the shortcomings of the US disclosure regime that the Interactive Investor campaign seeks to emulate. Under the rules introduced by the US Securities and Exchange Commission in 2004, US firms must disclose portfolio managers’ holdings in seven bands ranging from none to over $1m. While that tells you something, it doesn’t tell you how much of the manager’s total wealth it represents. But then requiring that sort of disclosure might be a step too far even for transparency enthusiasts.
Some sceptics suggest it is a bad idea to force disclosure of holdings at all as this might offer false reassurance to investors. But the proposal received 88% backing in a poll that Interactive Investor ran of visitors to its website and the FCA should take note.
There is a very strong argument that firms should be required to disclose the information to investors who can then make of it what they will. Since three quarters of the respondents in the poll said they would be more likely to invest in a fund if the manager was personally invested, it would probably be in most firms’ interests to do it anyway.
To contact the author of this story with feedback or news, email David Wighton