The Midas curse of outsourced funds: How incentive contracts turn gold into risk

Abstract

In a growing trend, mutual fund families are outsourcing the task of portfolio management 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 twice as risky as in-house funds, which leads to their underperformance. However, fund families can curb the excessive risk-shifting by (i) hiring multiple external advisors simultaneously (co-management), (ii) hiring geographically proximate external advisors (co-location), and (iii) invoking the reputation of the external advisor(s) while marketing the fund (cobranding).

Keywords: Mutual fund, Outsourcing, Risk-shifting, Contracts

JEL Classification: G11, G20, G23