Two of our recent blog articles outlined factors to consider when picking a mutual fund (Tips on Picking a Mutual Fund Part I and II). We included the Morningstar® stewardship grade, which is based on five components: regulatory history, board quality, manager incentives, fees, and corporate culture. A good stewardship grade helps you pick funds that, on the surface at least, have a tendency to focus on investors’ best interests. The manager incentives component of the stewardship grade considers the extent to which the managers invest in their own fund. Unfortunately, many funds are not yet given a stewardship grade by Morningstar®.

In 2005, the Securities and Exchange Commission began requiring mutual funds to disclose manager investments. Manager investments must now be reported in broad bands up to $1 million. Clearly, it would be more meaningful if the requirement exceeded $1 million but it seems logical that a million dollars should be sufficient to motivate most anyone.

Several articles we’ve come across have reported the results of a 2009 Morningstar® study regarding managers’ ownership in their own funds. According to those articles, that study indicated that less than 50% of stock fund managers invest in the funds they manage.

A July 6th, 2008 article by Chuck Jaffe of MarketWatch, stated that “Russel Kinnel, director of fund research for Morningstar®, said that he believes there is a direct correlation between investing in a fund and performance.” Jaffe went on to say that “Kinnel pointed out that in Morningstar’s fund analysis’ ‘picks’, the average investment by managers was $370,000, compared with $54,000 for the average analyst’s ‘pan’.”

There can be many reasons a fund manager would not want to invest a significant amount of money in a fund he/she manages. They may be relatively young and not have a lot of discretionary cash to invest or they may be managing a target date fund for seniors much older than they are. A manager may manage a municipal bond fund from a state other than the state he resides in. For more narrowly focused funds, managers who want to be broadly diversified would want to limit their exposure in a sector or niche fund. Nevertheless, the lowest band for reporting to the SEC is $0 to $10,000. In most cases, managers could improve investors’ confidence by at least investing the minimum band amount.

In a recent article in Business Week by Lewis Braham titled “Betting Their Own Money” (January 25th, 2010), Mr. Braham quoted a 2009 Morningstar® study that “managers with more than a $1 million stake in their own funds beat 58% of peers, on average, over the past five years. Funds with no manager investment beat 46% of peers.”

According to Braham’s article, Fidelity encourages its managers to invest in at least one fund they manage. Nevertheless, he says, most of Fidelity’s managers are compensated by fund performance. The article goes on to discuss several fund companies that require their managers to have significant investments in the company’s funds. Included were Royce & Associates, Southern Asset Management, Janus, T. Rowe Price, Davis Advisors and Dodge and Cox, to name a few.

Braham’s article includes a table of funds with “A” stewardship grades whose 10-year annualized returns beat from 83% to 99% of their peers. Since many funds do not have stewardship grades assigned by Morningstar®, Braham suggests that you may want to check the Statement of Additional Information included with a fund’s prospectus.

There are many important criteria to consider when picking a good mutual fund. Taking a bit of time to ferret out fund managers’ stakes in the funds they manage may well be worthwhile.

Note: Fund companies mentioned in this article and indirect references to funds mentioned in Mr. Braham’s article should not be construed as a recommendation by Patterson Advisors. We recommend readers seek the guidance of their own investment advisor before considering any investment.