The Risk of Outsourcing: How External Advisors Influence Mutual Fund Performance

Jung Hoon Lee, Saurin Patel, and Shyam Sunder Venkatesan

♦ Mutual fund families increasingly outsource the portfolio management task to external advisors. The high-powered incentive contract offered to external advisors, presumably an optimal outcome, implicitly creates convexity in their payoff. We provide causal evidence that this convexity makes the conditional portfolio choice of outsourced mutual funds about twice as risky as in-house funds, which leads to their underperformance. However, fund families can curb excessive risk-shifting unconditionally by: invoking the reputation of external advisor(s) when marketing the fund (co-branding) and hiring geographically proximate external advisors (co-location). Hiring multiple external advisors simultaneously (co-management) is also effective, specifically when underperforming.

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