Does Skin in the Game Matter?

This post comes to us from Martijn Cremers of Yale University, Joost Driessen of the University of Amsterdam, Pascal Maenhout of INSEAD and David Weinbaum of Syracuse University.

In our forthcoming Journal of Financial and Quantitative Analysis paper, Does Skin in the Game Matter? Director Incentives and Governance in the Mutual Fund Industry, we investigate whether effective governance, particularly director ownership, is associated with superior mutual fund performance, and if so, what economic mechanism could explain that.

We assemble a unique database on the fund holdings of the members of the largest equity mutual fund boards of directors, and investigate whether mutual fund performance is related to the ownership stakes of the directors overseeing those same funds. Specifically, for all actively managed equity funds that belong to the top 25 equity mutual fund families as of January 1996, we collect information on the ownership stakes of all independent and non-independent directors.

We find that directors’ ownership stakes in the funds they oversee are related to the subsequent performance of the funds: funds with low director ownership perform poorly. This underperformance has sizeable statistical significance and is economically large. This is true for ownership both at the fund family level and at the individual fund level. Funds in mutual fund families in which ownership by independent directors is low generate average annual abnormal returns of -2.54%. Similarly, funds with low ownership by non-independent directors generate average annual abnormal returns of -2.48%, and funds with low ownership by independent directors generate annual abnormal returns of -2.01%. The relation between ownership and performance is not linear, rather it is driven by the significant underperformance of low (and often zero) ownership funds. We do not find significant underperformance for funds with intermediate or high ownership.

In order to interpret our results, we distinguish between the monitoring and private information hypotheses by considering the performance of directors’ investments in the funds they oversee. In contrast to the results at the fund level, we find no link between lack of ownership and underperformance at the director level, which is evidence against the private information hypothesis. Further, we use various proxies for the importance of monitoring to show that the relation between director ownership and fund performance is driven by the underperformance of funds where monitoring is important, but ownership by directors is low. Third, we investigate the extent to which our results are driven by fees. We find that while fees are indeed higher in low director-ownership funds, and this does explain part of our results, it in fact explains a surprisingly small fraction of the results. This suggests that the role of mutual fund boards of directors extends well beyond fee negotiations.

The full paper is available for download here.

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