From 1980 to 2014, the percentage of American households that owned mutual funds rose from 5.7 percent to 43.4 percent. At the beginning of 1980, mutual funds held only around 4 percent of all U.S. equity. However, that figure is now around 30 percent. That increased share is basically explained by the fact that direct individual ownership of stocks dropped over this period from roughly 50 percent to about 20 percent. And while index and other passively managed funds are gaining ground, actively managed funds control the lion’s share of the mutual fund market.
What many investors don’t know is that a significant number of mutual fund companies outsource the management of their funds to subadvisory firms. In a typical outsourcing arrangement, the fund family retains marketing and distribution fees while the external advisor obtains the management fees. The question for investors is: does outsourcing improve performance?
In 2008, 24 percent (20 percent) of all global mutual funds (mutual fund assets) were managed by subcontractor firms. One theory behind outsourcing in international markets is that local managers may provide benefits in the form of privileged access to information and better connections to the local authorities.
The authors’ study covered the performance of global funds during the period from 2001 to 2008. The following is a summary of their findings:
For companies that manage both outsourced and in-house funds, the in-house funds outperform outsourced funds by 0.85 percent per year (57 percent of the expense ratio). The data is highly statistically significant (with a t-stat of 3.7).
Management companies allocated 44 percent more IPOs to their in-house funds than to their outsourced funds (and that’s statistically significant at the 1 percent level of confidence). This effect proved stronger for domestic (relative to the domicile of the management company) IPOs, where in-house funds receive 49 percent more IPOs, and for IPOs taking place during higher overall IPO activity, when in-house funds receive almost 50 percent more of the offerings.
In-house funds are more likely to buy a stock before it appreciates. The correlation between buy trades and subsequent stock returns is about one-third higher for in-house funds than for outsourced funds (again significant at the 1 percent level of confidence). This indicates privileged use of information.
In-house funds cross-trade twice as much with affiliated outsourced funds than with the rest of the market, with cross-trading peaking during times when in-house funds face steep outflows in excess of 5 percent of their total net assets. Subcontractors are likely to designate outsourced funds as providers of liquidity to their in-house funds that are experiencing distressed redemptions.
The preferential treatment is explained by agency problems, increasing with the subcontractor’s market power and the difficulty of monitoring the subcontractor.
There’s more preferential treatment when the fund family and the management company do not share an official language and when the market share of the management company is higher. Outsourced funds at a management company that does not share an official language with the fund family underperform other outsourced funds by about 2.64 percent per year, as measured by four-factor alpha. Outsourced funds run by management companies with a 10 percent higher market share in the outsourcing market of the fund’s investment objective underperform other outsourced funds by about 1.49 percent per year (and that’s significant at the 5 percent level of confidence or better).
Interestingly, the authors found that higher subadvisory fees are associated with both better performance of outsourced funds and less preferential treatment, suggesting that preferential treatment is a form of “in-kind” compensation substituting for direct monetary payments.
The bottom line is that management companies treat their own funds more favorably than those they manage on behalf of other fund families. In-house funds outperform outsourced funds on both a raw and risk-adjusted basis.
Outsourced funds underperform funds managed in-house by 0.62 percent a year when benchmarked against a four-factor model (beta, size, value and momentum), with the underperformance being highly significant (a t-stat of 3.55). Using a six-factor model (adding the bond factors of term and default risk), the underperformance was 0.55 percent (with a t-stat of 3.35).
These are significant effects given that the typical equity fund in the sample underperforms its proper benchmark by about 0.8 percent.
The underperformance was not explained by higher fund expenses, as outsourced funds don’t differ from internally run funds in terms of expense ratios.
The underperformance was not explained by higher turnover and thus higher trading costs. Turnover of outsourced funds was actually slightly lower than the 90 percent turnover of internally managed funds.
Given the evidence of the poor performance of outsourced funds, why do fund families outsource? One theory is that a fund family might outsource when it runs into capacity constraints. Chen, Hong, Jiang and Kubik tested for this, and they found that there’s a statistically significant relationship between the number of funds and a firm’s decision to outsource. Unfortunately, investors would be better off if the fund family simply limited its offerings. However, that would also then limit the management company’s profit opportunities.
Prior research has documented that investors tend to pick a fund family first. Only then do they choose the funds (from among that family’s menu) in which they will invest. Given that behavior, mutual fund families often offer more product differentiation, despite the negative outcomes for investors.
The Bottom Line
The two studies presented here provide clear evidence that when investors are making their fund choices, they should include in their due diligence a check to see if the fund family is outsourcing the management of any of its funds.
In addition, they indirectly provide further evidence that active management is a loser’s game (outsourcing only makes it more so). One would think that if anyone had the skills and resources to identify the few future active managers that will beat their benchmarks, it would be other active managers. The evidence from this research shows how poorly they do at that task.
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