Skin in the game: a sign of aligned interests

One of the most notable advantages that investment companies offer over their open-ended fund counterparts is their corporate structure. Like other stock market vehicles, they operate with independent boards whose mandate is to serve the best interests of shareholders. These directors play a crucial role in holding an investment company’s managers to account – even to the extent of changing manager where they believe this would be to investors’ benefit.

But are investment company directors useful in another way too? For some stock market investors, directors’ dealings are a key indicator of when to trade in a particular share. They reason that directors are well-placed to know when the company is heading for a period of strong performance, or a period of disappointing trading. So a director buying shares could be a sign that it’s time to invest in the company; equally, a share sale might be a signal to investors to get out.

Does this work in the investment company sector? Well, an analysis published in the latest edition of Citywire’s Investment Trust Insider magazine sets out to answer this question. It looked at a number of closed-ended funds where directors have declared significant transactions and then sought to establish whether there was a correlation between the nature of the deal and the investment company’s subsequent performance.

The first point to make is that investment company analysts like to see directors take stakes in their funds – to put some “skin in the game” in investment parlance. Most directors do exactly that – more than eight in 10 had stakes in their funds according to an analysis published at the end of last year by Canaccord Genuity.

It’s also important to point out that directors would usually be “insiders” in legal terms. If they buy or sell shares because they are privy to market sensitive information, they’re breaking the law. It is fine for directors to increase their stakes in a fund because they were enthused by the optimistic tone of the fund manager’s most recent presentation on markets to the board, but not because they know the fund will very shortly announce, say, an unexpected upwards revaluation of a key holding.

Citywire’s analysis appears to show that investment company directors’ dealings can, in certain circumstances, be a signal of what is to come for investors, particularly in funds that trade in illiquid assets. Equally, however, investors would be wise to be cautious – not every purchase by a director turns out to be a sure-fire sign investors should fill their boots; nor is every sale a harbinger of doom.

Still, it is certainly worth keeping an eye on directors’ dealings, particularly in funds where you have an interest. At the very least, they should be a reason to look more closely at the prospects of the fund in the months to come, even if you subsequently decide to take no action.

Investors should also welcome the transparency of investment companies – the fact that insiders cannot act without disclosing their moves to the wider market. The declared stakes of directors – and fund managers for that matter – in their investment companies can also be a reassuring sign that their interests are aligned with those of investors.