The Globe and Mail, Report on Business
Published November 15, 2008

It's always hard to pick someone to manage your money. You want people with experience and an investment philosophy you're comfortable with. You want to be sure they have the capacity, flexibility and resources to do their thing. And you want evidence that they've made money for their clients over the long term.

In a paper published this week, my partner Scott Ronalds adds another criterion to the list. Are the managers investing alongside you? Are they in the same fund (or set of stocks) that you are? Are they sharing in the gains, and more relevant today, the losses? In other words, are they eating their own cooking?

He points out that sophisticated buyers of hedge funds often view "hurt money" (managers with lots of money in the fund) as the best form of risk control. In this regard, he quotes David Swensen, the chief investment officer of Yale University: "Investors might sensibly consider placing money with fund management companies that demonstrate high degrees of co-investment by the firm's portfolio managers."

Regrettably, the paper also points out that the industry comes up short on the "eat your own cooking" measure. A recent study conducted in the U.S. by research firm Morningstar looked at roughly 6,000 funds and found that nearly half of all domestic equity funds had no manager ownership.

It should be noted that while the number is appalling, there are structural reasons why it won't ever get to 100 per cent. For example, the manager may have money invested in another fund or portfolio that mirrors the public version. Sometimes there are jurisdictional or regulatory reasons that prevent a manager from investing in their fund.

In any case, I don't know what the number is in Canada, but I do know the math doesn't work. There are thousands of mutual funds and structured products to choose from and a constant flow of new ones. Talented new managers are always emerging, but not to the tune of one or two a week. The reality is that good managers at big firms run multiple funds, which are sometimes quite diverse in their mandates.

On many mutual fund websites, the funds managed by the portfolio managers are listed below their profiles. I recently came across a piece written by David Taylor, one of the stars at Dynamic. Under his signature was a list of six funds he is lead manager on. They included a variety of mandates described as "value," "dividend," "balanced" and "contrarian." The demands put on Mr. Taylor are not uncommon.

Not surprisingly, the industry is reluctant to reveal who is eating at home. There are lots of instances where managers are in the fund alongside their clients, but there are too many products where they're not. It's unlikely that a fund manager has a significant portion of his/her net worth in the fifth fund they have been given to run. And I would hazard a guess that there aren't too many investment bankers or managers with their own money in the structured products they bring to market.

Co-investment recently got a poster boy with the startup of a new asset manager, Edgepoint Capital Partners. The company was started by three ex-Trimarkers - Tye Bousada, Geoff MacDonald and Patrick Farmer - and backed by Trimark founder Bob Krembil. The trio has come up with an ingenious way to kick-start the firm and assure positive client/manager alignment.

Last week they closed a $222-million initial public offering for a company called Cymbria (CYB-TSX), which is essentially a closed-end fund. Investor money will be used to acquire a concentrated portfolio of stocks, which will be run by Mr. Bousada and Mr. MacDonald. The two of them are putting a major portion of their personal wealth into Cymbria.

In addition to the perfect alignment of interests, there are reasons why an investor would buy Cymbria. It can own private companies, borrow money to invest (not the focus here) and importantly, be assured that the money will stay in place (closed-end equals no redemptions). The latter allows them to take a longer-term view when buying illiquid and/or out-of-favour stocks.

Closed-end funds have their issues of course. They often trade at a discount to net asset value and the initial buyers are required to pay the sales commissions and startup costs. In the case of Cymbria, however, these negatives are largely offset, because in addition to getting a piece of Mr. Bousada's and Mr. MacDonald's personal portfolio, investors receive a 22-per-cent interest in their company, Edgepoint Wealth Management, at zero cost. Unitholders will share in the growth of the global portfolio and the asset management company that runs it.

The recent round of consolidation in the industry, where the owners of firms such as Addenda, Phillips Hager & North and Saxon have cashed out, is a reminder of the value that can be created by a successful asset manager. If Edgepoint's family of mutual funds grows, the ownership stake held by Cymbria could be a substantial part of the portfolio in the coming years.

Mr. Krembil and crew have gone to great lengths to ensure that there is an alignment of interests. However it's done, make sure the chef is at the dinner table beside you.