The winners of the 2022 Hillsdale Investment Management — CFA Society Toronto Research Award are Saurin Patel of the Ivey School at the University of Western Ontario, Jung Hoon Lee of the Owen Graduate School of Management at Vanderbilt University, and Shyam Venkatesan of the Ivey School at the University of Western Ontario for their research paper entitled Outsourced Funds and Risk-Taking: A Tale of Two Contracts. 

In their paper, the three winning researchers examine important issues for investors that arise when mutual funds outsource the investment management function of their businesses. Outsourcing enables mutual fund families to divide work by specialization, gain market share by expanding their product offerings, and gain cost efficiencies. Over 30 percent of equity mutual funds sampled by the researchers currently delegate investment management to an external, unaffiliated investment advisor. 

However, outsourcing fund management can give rise to agency problems. The firm boundaries prevent the outsourcing fund families from choosing the portfolio managers or analysts, the compensation structures used, and the monitoring mechanisms in place, and in this imperfect informational environment, offering the advisor a contract with high-powered incentives is often seen by outsourcing fund families as the best available option. 

The authors’ winning paper investigates the effect of compensation contracts on the conditional risk choice of outsourced mutual funds. It finds that, compared to funds managed in-house, outsourced funds display twice as much strategic risk-shifting in their efforts to maximize the value of payouts, and that risk-shifting, on average, leads to poor performance. The paper establishes that a fund’s outsourcing status has a causal effect on risk-shifting. The evidence presented shows this behaviour to be more consistent with a motive to manage the risk of contract termination and less with a motive to exploit the optionality in portfolio managers’ compensation contracts. The authors explain how outsourcing fund families can employ additional mechanisms to mitigate the risk-shifting behaviour of outsourced managers. 

The role of agency arrangements in the performance of outsourced funds 

Previous research has shown that the propensity of fund closure due to poor performance is higher when a fund is outsourced, and that, compared to funds managed in-house, outsourced funds tend to have lower returns. It is suggested that these lower returns could be due to outsourced funds taking on significantly less risk. Alternatively, the authors suggest that the lower returns could be due to the outsourced funds conditionally taking more risk than funds that are managed in-house, potentially leading to lower returns. They provide two distinct reasons for this greater risk-taking, which are explained below. 

In their analysis, the authors focus more on strategic mid-year risk-shifting than average risk-taking. This is because advisors and portfolio managers of outsourced funds implicitly or explicitly face convex or option-like incentives that encourage them to increase their portfolio risk in the second part of the year, especially when the mid-year fund performance is close to their performance benchmark. To beat the benchmark, increasing volatility is most valuable in this context, and this incentive dissipates as fund performance deviates from the benchmark return on either side. The authors suggest that this desire to retain management contracts and avoid termination significantly influences excessive risk-shifting in outsourced funds. They call this phenomenon the employment hypothesis of risk-shifting. 

The compensation contracts offered by investment advisors to portfolio managers (i.e., the employees who make the day-to-day portfolio decisions) are very different from the contracts fund families offer to investment advisors. Portfolio manager contracts often have significant bonus components based on the fund’s performance and, importantly, have an asymmetric payoff. The asymmetric contracts ensure that the manager is not penalized if the fund underperforms the benchmark. As in the case of the employment hypothesis, managers with asymmetric contracts have an incentive to increase their portfolio risk in the second part of the year, especially when the excess return relative to the performance benchmark is close to zero. Outsourcing arrangements tend to accentuate these incentives, as firm boundaries impede monitoring by the outsourcing fund family. The authors call this phenomenon the compensation hypothesis of risk-shifting. 

Interestingly, the authors find the desire to retain management contracts and avoid termination drives excessive risk-shifting in outsourced funds more than the optionality in portfolio managers’ compensation contracts. 

However, outsourcing fund management can give rise to agency problems. The firm boundaries prevent the outsourcing fund families from choosing the portfolio managers or analysts, the compensation structures used, and the monitoring mechanisms in place, and in this imperfect informational environment, offering the advisor a contract with high-powered incentives is often seen by outsourcing fund families as the best available option. 

The authors’ winning paper investigates the effect of compensation contracts on the conditional risk choice of outsourced mutual funds. It finds that, compared to funds managed in-house, outsourced funds display twice as much strategic risk-shifting in their efforts to maximize the value of payouts, and that risk-shifting, on average, leads to poor performance. The paper establishes that a fund’s outsourcing status has a causal effect on risk-shifting. The evidence presented shows this behaviour to be more consistent with a motive to manage the risk of contract termination and less with a motive to exploit the optionality in portfolio managers’ compensation contracts. The authors explain how outsourcing fund families can employ additional mechanisms to mitigate the risk-shifting behaviour of outsourced managers. 

The role of agency arrangements in the performance of outsourced funds 

Previous research has shown that the propensity of fund closure due to poor performance is higher when a fund is outsourced, and that, compared to funds managed in-house, outsourced funds tend to have lower returns. It is suggested that these lower returns could be due to outsourced funds taking on significantly less risk. Alternatively, the authors suggest that the lower returns could be due to the outsourced funds conditionally taking more risk than funds that are managed in-house, potentially leading to lower returns. They provide two distinct reasons for this greater risk-taking, which are explained below. 

In their analysis, the authors focus more on strategic mid-year risk-shifting than average risk-taking. This is because advisors and portfolio managers of outsourced funds implicitly or explicitly face convex or option-like incentives that encourage them to increase their portfolio risk in the second part of the year, especially when the mid-year fund performance is close to their performance benchmark. To beat the benchmark, increasing volatility is most valuable in this context, and this incentive dissipates as fund performance deviates from the benchmark return on either side. The authors suggest that this desire to retain management contracts and avoid termination significantly influences excessive risk-shifting in outsourced funds. They call this phenomenon the employment hypothesis of risk-shifting. 

The compensation contracts offered by investment advisors to portfolio managers (i.e., the employees who make the day-to-day portfolio decisions) are very different from the contracts fund families offer to investment advisors. Portfolio manager contracts often have significant bonus components based on the fund’s performance and, importantly, have an asymmetric payoff. The asymmetric contracts ensure that the manager is not penalized if the fund underperforms the benchmark. As in the case of the employment hypothesis, managers with asymmetric contracts have an incentive to increase their portfolio risk in the second part of the year, especially when the excess return relative to the performance benchmark is close to zero. Outsourcing arrangements tend to accentuate these incentives, as firm boundaries impede monitoring by the outsourcing fund family. The authors call this phenomenon the compensation hypothesis of risk-shifting. 

Interestingly, the authors find the desire to retain management contracts and avoid termination drives excessive risk-shifting in outsourced funds more than the optionality in portfolio managers’ compensation contracts. 

Overall, the authors find that managers of outsourced funds tend to take on more risk, conditional on their mid-year performance. This strategic risk-taking could explain why outsourced funds tend to underperform in-house managed funds. 

How to address agency problems 

Notably, the authors examine the mechanisms that can mitigate the above-discussed agency problems. Specifically, they note that contractual arrangements, such as co-managing, co-locating, and co-branding, can mitigate the excessive risk-shifting by outsourced funds. 

Firstly, regarding co-managed funds, they note that when multiple advisors manage the same fund (co-managing), firm boundaries among them limit the extent of collusion and promote effective peer monitoring. 

Secondly, the authors maintain that geographical proximity matters for effective monitoring. They expect to observe less risk-shifting among funds where the fund family and the advisors are located near each other (co-locating). 

Thirdly, the authors look at co-branded funds. Often, fund families partner with unaffiliated external advisors and put the advisor’s name in the fund name to attract flows using the advisor’s reputation (co-branding). Due to co-branding, the potential reputation cost can effectively mitigate potential conflicts of interest and reduce risk-shifting. 

To empirically test their hypotheses concerning mitigating factors, the authors use the universe of US equity mutual funds from 1999 to 2018. Daily fund return and the return of the fund’s self-designated benchmark are used to estimate the extent of risk-shifting. In their empirical results, the authors find evidence to support the view that these mechanisms do moderate the actions of the outsourced portfolio managers. In all three instances, they find that mid-year risk-shifting diminishes when the fund complex takes the hypothesized additional measures to reduce agency frictions. 

A significant contribution to understanding outsourced funds 

The winning researchers’ paper makes a significant contribution to understanding outsourced funds. It sheds more light on aspects of contract design and provides a new perspective on the efficiency of existing contracts awarded to advisors of outsourced funds. Its findings should encourage outsourcing fund complexes to realize that the contract they provide is incomplete and that additional mechanisms are needed to improve investor outcomes. 

The panel of judges stated, “The paper will be valuable for practitioners to read and debate during their decision-making process of hiring and retaining an outsourced firm. The result will be a more thorough discussion about taking on an acceptable level of risk and a better understanding of the factors that can mitigate this risk.” 

Chris Guthrie, CEO of Hillsdale Investment Management, co-sponsor of the award, commented, “The winning paper highlights the importance of a properly structured incentive agreement, including co-branding, co-management, co-location and performance-based fees, in modifying the asymmetric payoff of a typical investment management contract. The authors find that the introduction of these measures leads to less ‘risk-shifting’ which otherwise leads to significant welfare loss by investors in outsourced funds. We wholeheartedly agree.” 

The authors note that the study of advisors’ and portfolio managers’ contracts in academic literature has been limited by the fact that the Canadian Securities Administrators’ (CSA) and the US Securities and Exchange Commission’s (SEC) rules did not require their disclosure until 2005. 

Although outsourced funds are required to disclose some critical features of the managerial compensation structure, the exact details remain primarily unavailable. The authors’ findings present additional grounds for regulators to improve disclosure requirements so that investors can clearly understand the financial incentives of the outsourced managers they hire to make portfolio decisions. 

Concluding thoughts 

The research paper’s findings provide information for the mutual fund industry in Canada and internationally to design better compensation contracts in outsourced funds, which account for over 30 percent of the equity funds offered. The paper highlights potential ways to mitigate agency problems arising from outsourcing and asymmetric contracts through additional contracting or monitoring arrangements. This information gives both fund families and securities regulators in Canada and the US more tools to improve the welfare of investors.  

The Hillsdale Investment Management – CFA Society Toronto Research Award is open to researchers globally who conduct research related to Canadian capital markets, including both academics (e.g., professors and students) and practitioners. Author(s) of the winning research paper are awarded CAD $10,000. Research papers are reviewed by a panel of CFA charterholding investment experts to ensure they are in line with the rigorous values and standards embodied in the CFA designation.