Outsourcing Mutual Fund Management: Firm Boundaries, Incentives, and Performance (Digest Summary)

The authors investigate the relationship between an outsourced investment management process and the performance of mutual funds. Their results confirm the significant underperformance of outsourced funds compared with funds managed internally by their fund families. They also explain how the agency problem and a reliance on steeper incentives (e.g., closure of funds) can contribute to the underperformance of outsourced funds.

Mutual fund companies (i.e., fund families) market and distribute mutual funds to individual investors. The investment management process may be executed by the fund family, but it is often outsourced to an external investment advisory firm because of cost efficiencies and capacity constraints. The family of an outsourced fund monitors investment performance in terms of return and risk-taking behavior.

Outsourcing is a common practice; more than 40% of fund families at least partially delegate the management process to an unaffiliated adviser. In terms of total net assets, outsourced funds represent 26% of funds in a typical fund family. The authors also note that the typical fund age of an outsourced fund is significantly shorter than that of funds managed internally and conclude that fund families are more likely to close outsourced funds, often because of poor performance or excessive risk-taking behavior.

The authors establish a clear causal relationship between outsourcing and investment underperformance of at least 50 bps a year. Outsourced funds tend to produce lower alpha with roughly the same market beta. The authors explain that because of firm boundaries, fund families find it more difficult to extract performance from externally managed funds (i.e., the agency problem).

In an outsourcing relationship, the fund family retains the ability to replace the fund manager or close down the fund, which serves as a strong performance incentive for the adviser. The authors conclude that because of the reliance on this incentive, the fund family effectively discourages the adviser from pursuing strategies that may lead to abnormal returns, such as small caps or IPO participation, which further contributes to the observed underperformance of outsourced funds.

The research is based on monthly performance data and fund characteristics from the CRSP Mutual Fund Database for the period of 1994–2007. The authors combine the data with the names of the investment advisory firms from the Thomson Mutual Fund Holdings Database. A fund is categorized as outsourced if one of its advisers is not affiliated with the fund family based on U.S. SEC disclosures by investment advisers.

The authors first calculate descriptive statistics based on the sample of more than 2,000 U.S. funds and discuss observed differences between outsourced and internally managed funds. Subsequently, they compare fund performance by running a series of multifactor models in order to benchmark performance to a number of equity and bond risk factors. The magnitude of underperformance is measured using each factor model, with statistical significance confirmed using t-statistics.

In addition, the authors perform a cross-sectional regression to confirm that a fund’s outsourced status is significantly linked to a decrease in generated alpha. The underperformance persists when the authors include controls for fund and family characteristics (e.g., fund size, management fees, family size, and fund age). A probit regression is used to confirm that a fund’s outsourced status is significantly linked to an increased probability of closure by the fund family in the case of unsatisfactory investment results.

But the performance analysis is limited to equity and bond risk factors. Specialized funds (e.g., real estate, natural resources, and hedge funds) with different performance drivers are not analyzed in detail. These funds are worth considering because they are more likely to be outsourced by a family; specific expertise is required to pursue such strategies.

The authors show the magnitude of underperformance of externally managed funds and present possible explanations. They note that mutual fund investors are typically not aware of whether the management of their funds is outsourced or internal. Therefore, this research may encourage investors to seek out this information. It may also be useful for fund families in making the decision between outsourcing funds and managing them internally.

Overall, the research is comprehensive and includes robust controls and a series of empirical tests that support the conclusions. The addition of analysis of specialized funds could make the study even more relevant from the perspective of investors and academics.