Skin in the Game: Mutual Funds and Performance

If ownership by directors plays an economically and statistically significant role in fund performance, it stands to reason that funds in which directors have low ownership significantly underperform.

Conflicts of interest in mutual funds between managers, fund sponsors, and shareholders are, in some ways, the nature of the beast given that mutual fund managers benefit from high-paying risky investments while sponsors and shareholders tend to benefit from lower risk investments.

Less obvious is the importance of director incentives in mutual funds or the extent to which effective corporate governance is related to mutual fund performance. If ownership by directors plays an economically and statistically significant role in fund performance, it stands to reason that funds in which directors have low ownership, or “skin in the game,” significantly underperform.

New research by David Weinbaum, associate professor of finance in the Whitman School of Management at Syracuse University, hypothesizes that lack of ownership could indicate a director’s lack of alignment with fund shareholders interests. Published in the Journal of Financial and Quantitative Analysis, the research also investigates whether or not directors may have superior private information on future performance.

“We look at whether director ownership as a proxy for effective governance is associated with superior mutual fund performance and if so, what economic mechanism could explain that,” says Weinbaum.

Through use of a unique database on ownership stakes of equity mutual fund directors, the team analyzed whether effective mutual fund governance is related to performance, finding that direct ownership stakes are important for fund performance.

“Specifically, low ownership funds significantly underperform. Funds with higher ownership by non-independent directors have lower fees. However, this only explains part of the relation between ownership and performance.”

The team concluded that the link between low director ownership and poor fund performance were attributed to:

1. Lack of director incentives to act in the best interests of shareholders, and

2. Private information used by director when deciding in which funds to invest.

“However, the private information theory is untenable as we show that directors on average invest in funds that do not outperform the funds that they do not invest in,” says Weinbaum. “Therefore, the link between director ownership and fund performance is driven by the underperformance if funds that would benefit from improved alignment incentives in the form of director ownership, but where those incentives are missing.”

Source: Whitman School at Syracuse University