Management Sub-Advising in the Mutual Fund Industry

Abstract

This is a study of how contractual mechanisms can mitigate agency conflicts in sub-advised mutual funds. Sub-advising contracts allow fund families to expand their product offerings to include new investment styles and thereby gain market share. We show that costly contractual arrangements, such as co-branding, multi-advising, and performance-based compensation, can mitigate agency conflicts in outsourcing and protect investors from potential underperformance. Fund families will find it cost-effective to implement such incentive mechanisms only when investors are sophisticated in assessing manager skill. The findings help to explain why a large percentage of fund families outsource their funds to advisory firms.

Keywords: Outsourcing, Sub-advisor, Mutual Funds, Management Company, Incentive Contracts, Fund Performance, Market Share, Agency Issue.

JEL Classification: G11, G23, M55