What does "Skin in the game " mean in finance?

A board director or fund manager having ‘skin in the game’ – investing their own money alongside that of their clients – aligns their interests and is a sign of commitment, but does it lead to stronger investment performance? 

‘Skin in the game’ – meaning board directors or fund managers putting their own capital in a company or fund – is seen as a hygiene test by many investors. After all, if they won’t back their own investment, why should investors? It is a rational way to align the interests of shareholders and management, but does it lead to stronger performance?

It shows commitment to the company and also means they lose or win with the rest of the shareholders. The theory goes that this will ensure they make better judgements and manage risk more effectively because their own capital is at stake.

Many have sought to harness this in their investment strategy. Hedge fund manager Bill Ackman, for example, whose investment strategy is premised on turning round failing companies, puts incentive structures in place for chief executives that mean they lose their entire investment if the share price falls, but can potentially reap enormous rewards if they succeed in rebuilding the business. He believes this creates clear and meaningful incentives. 

Others will follow directors’ buying, believing that if ‘insiders’ are buying shares, they believe the business is cheap based on its future prospects. In each case, investors are trying to replicate the experience of entrepreneurs, wanting directors to have a sense of ownership over their business that encourages them to look after it better.

Investment trusts are just one type of mutual or collective fund where skin in the game can matter. As a listed company they are required to disclose any directors’ holdings in the trust along with those of any significant (three percent or more) shareholder. This may include the fund managers. Fund managers having a significant holding in the trust can help to keep them on their toes and ensure they don’t take careless risks, while invested board directors may be more inclined to hold the fund management team to account.

The bi-annual Investec report into skin in the game for investment trusts aims to expose those fund groups with little or no holdings in the trust, while highlighting those who have made significant commitments. The Pershing Square management team, for example, holds £1.3bn in the trust, while the Rothschild family have an £834m stake in RIT Capital.

The June 2021 report showed how widespread the concept has become, with a seven-fold increase in share purchases by boards and fund managers in their investment trusts over the past decade. Boards and managers had £4.81bn invested in their trusts, up from £687m in 2010.

Open ended collective funds, such as OEICs and unit trusts, don’t have equivalent disclosure requirements so it can be harder to understand the extent to which their managers have skin in the game. Research by interactive investor found that 88% of visitors to its website felt disclosing personal holdings should be mandatory for all fund managers, with 77% saying they were more likely to invest where the fund manager had too.

Some companies may be too big for directors’ shareholdings to make a difference to performance. Is a non-executive director holding a significant stake in, say, a large bank or oil company, really in a position to influence the share price?

It may also create skewed incentives. For example, the management team may be incentivised to pump up the share price at the expense of long-term returns. It may encourage them to take too much short-term risk. There is also the opposite problem: if a fund manager is nearing retirement and has a large personal holding in an investment trust, for instance, they may be tempted to retreat into cautious investments. In both examples, the needs of shareholders can diverge from the interests of the manager.

The Investec report has never found a significant relationship between skin in the game and performance, though the very popular trusts – Lindsell Train, Fundsmith Equity, Scottish Mortgage - all have large management shareholdings. There have been some egregious examples where management teams have held a dominant stake and have used it to pay themselves higher performance fees. Equally, skin in the game does not necessarily prevent poor governance. Neil Woodford had a hefty stake in his investment trust, Patient Capital, when it all went wrong in 2019.

If the management team does not have a significant stake, investors need to ask why. There may be good reasons – personal circumstances, high minimum investment levels – but it may also suggest they don’t believe in the product.

However, the level of commitment needs to be put in context. Is a £30,000 investment a significant incentive if the manager is worth £50m? These commitments can’t be looked at in isolation but need to be judged alongside other criteria to establish the extent of alignment of interest, such as firm structure or bonuses.

Skin in the game can be a useful tool to analyse the level of engagement of the management team and their willingness to back their own judgement. However, it cannot give the full picture and needs to be analysed alongside other metrics. The Fineco platform offers tools and resources you can use to help build up a more comprehensive picture of your investment options.