Outsourcing in the International Mutual Fund Industry: An Equilibrium View

• DOI: http://doi.org/10.1111/jofi.12259
• Author: DAVID SCHUMACHER,OLEG CHUPRININ,MASSIMO MASSA
• Date: 01 October 2015
• Published date: 01 October 2015

THE JOURNAL OF FINANCE •VOL. LXX, NO. 5 •OCTOBER 2015

Outsourcing in the International Mutual Fund

Industry: An Equilibrium View

OLEG CHUPRININ, MASSIMO MASSA, and DAVID SCHUMACHER∗

ABSTRACT

We study outsourcing relationships among international asset management firms.

We find that, in companies that manage both outsourced and in-house funds, in-

house funds outperform outsourced funds by 0.85% annually (57% of the expense

ratio). We attribute this result to preferential treatment of in-house funds via the

preferential allocation of IPOs, trading opportunities, and cross-trades, especially

at times when in-house funds face steep outflows and require liquidity. We explain

preferential treatment with agency problems: it increases with the subcontractor’s

market power and the difficulty of monitoring the subcontractor, and decreases with

the subcontractor’s amount of parallel in-house activity.

THE COMPLEXITY OF INVESTMENT DECISIONS and the need for specialized informa-

tion makes the outsourcing of portfolio management an important dimension

of the financial services industry. This is especially true in the international

arena, where outsourcing to local managers may entail benefits in the form of

privileged access to information and better connections to the authorities. For

example, a fund specializing in international investments, even if it is mar-

keted and sold by an American firm to American investors, may delegate the

actual trading decisions to a subcontractor manager located in another country,

often close to the investment focus of the fund. In 2008, 24% (20%) of all global

mutual funds (mutual fund assets) were managed by subcontractor firms.

However, outsourcing may create an array of agency problems ranging from

a simple lack of effort on the part of the agent to unfair treatment of his clients.

The subcontractor is often affiliated with a financial conglomerate that not only

manages funds on behalf of other fund families (“outsourced” funds) but also

markets its own brand of funds (“in-house” funds). In such cases, a conflict of

∗Oleg Chuprinin is with UNSW Business School, University of New South Wales, Massimo

Massa is with INSEAD, and David Schumacher is with the Desautels Faculty of Management,

McGill University. We thank Cam Harvey (the Editor), two anonymous referees, an anony-

mous Associate Editor, Viral Acharya, Juan Pedro Gomez, Pierre Hillion, Sergei Sarkissian, Jose

Scheinkman, Daniel Schmidt, Neal Stoughton, and Stefan Zeume, as well as seminar participants

at INSEAD, IFABS 2011, the 9th International Paris Finance Meeting, and EFA 2012 for their

valuable comments and suggestions. David Schumacher acknowledges research support from the

Institute of Financial Mathematics of Montreal (IFM2). We are also grateful to Prateek Mahesh-

wari for excellent research assistance. Some results presented here were previously part of a paper

entitled “Happy Losers: Subcontracting in International Asset Management.”

DOI: 10.1111/jofi.12259

2275

2276 The Journal of Finance R

interest may induce the management company to treat in-house funds more

favorably relative to outsourced funds.

In this paper, we examine the performance of global in-house and outsourced

mutual funds over the period from 2001 to 2008. We construct a unique data

set on international outsourcing relationships, in which, for every fund in the

sample, we identify both the principal (the outsourcing mutual fund family)

and the agent (the management company responsible for portfolio selection).

We ask whether management companies treat outsourced funds differently

when they are managed in parallel with the firm’s own brand of funds. If so,

we investigate and try to understand these differences in light of the fact that

both parties in the outsourcing relationship are professional asset management

firms that are aware of each other’s incentives. In doing so, we draw on several

predictions from principal-agent theory.

We document a series of results. First, in-house funds earn higher raw and

risk-adjusted returns than their otherwise similar outsourced counterparts.

For funds managed by the same company, outsourced funds underperform in-

house funds by 7.1 bps per month with a t-statistic of 3.66, as measured by the

four-factor α. This is about 85 bps per year or 57% of the fund’s annual expense

ratio. Throughout the paper, we test whether the observed performance gap

between affiliated in-house and outsourced funds can be interpreted as a form

of “preferential treatment.”

Second, we examine several mechanisms through which such preferential

treatment could take place. We test for preferential initial public offering (IPO)

and information allocation as well as for cross-trading between affiliated funds.

We find that management companies allocate more IPOs to their in-house funds

than to their outsourced funds. The aggregate weight of IPO stocks is about

44% higher in portfolios of in-house funds than in those of outsourced funds

(significant at the 1% level). This effect is stronger for domestic (relative to the

domicile of the management company) IPOs, where in-house funds receive 49%

more IPOs, and for IPOs taking place during higher overall IPO activity, when

in-house funds receive almost 50% more of the offerings.

Moreover, in-house funds are more likely to buy a stock before it appreciates.

The correlation between buy trades and subsequent stock returns is between

30% and 35% higher for in-house funds than for outsourced funds (significant at

the 1% level). This indicates privileged use of information that allows in-house

funds to place better trades and earn higher overall returns.

We further document that in-house funds cross-trade disproportionately

more (twice as much) with affiliated outsourced funds than with the rest of the

market. Importantly, cross-trading peaks during times when in-house funds

are in distress, that is, when they face steep outflows in excess of 5% of their

total net assets (TNA). Such focused cross-trading suggests a liquidity-based

channel: subcontractors are likely to designate outsourced funds as liquidity

providers to those in-house funds that experience distressed sell-offs.

Third, we investigate whether preferential treatment can be understood as

a manifestation of agency problems in the outsourcing market. We draw on the

Outsourcing in the International Mutual Fund Industry 2277

standard principal-agent framework of Holmstrom and Milgrom (1987)and

relate it to observable parameters of the outsourcing relationship, specifically,

to two measures of moral hazard: monitoring ability and bargaining power.

First, the harder it is for the principal to monitor the relationship, the less likely

he is to detect shirking by the agent. This increases the moral hazard of the

agent and leads to more preferential treatment. We use language similarities to

proxy for the monitoring ability of the principal fund family. We postulate that

when the family and management company do not share an official language,

it is harder to monitor. Second, the higher the market share of the agent in the

outsourcing market, the greater his bargaining power vis-`

a-vis the principal,

since the principal’s alternative outsourcing opportunities are limited. This

leads to more preferential treatment.

Our empirical results are consistent with the above predictions. We docu-

ment 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 from a management com-

pany that does not share an official language with the fund family underper-

form other outsourced funds by about 2.64% per year, as measured by the

four-factor α. Outsourced funds run by management companies with a 10%

higher market share in the outsourcing market of the fund’s investment ob-

jective underperform other outsourced funds by about 1.49% per year. These

results are robust to various specifications and significant at the 5% level or

better.

Next, we investigate whether preferential treatment simply implies that

outsourced funds constitute an inferior product, or whether it can be recon-

ciled with incentive provision consistent with a principal-agent equilibrium.

We focus on the task complementarity of managing outsourced and in-house

funds in parallel, the correlation between in-house and outsourced fund per-

formance, and the link between preferential treatment and the agent’s direct

compensation via subadvisory fees.

We first note that the tasks of managing in-house and outsourced funds

are complementary (e.g., information collection and the analysis of investment

opportunities benefits both fund types). In terms of incentive provision, this

implies that the higher the fraction of the in-house activity, the more effort the

agent will exert as a subcontractor because the effort “spills over” to in-house

funds. This spillover effect leads to less preferential treatment. In contrast,

the “inferior product” alternative predicts that a higher fraction of in-house

funds (i.e., a lower relative importance of outsourced funds) leads managers

to allocate less effort to outsourced funds. In line with the incentive provision

argument, we find that the fraction of the agent’s outsourced assets is posi-

tively related to preferential treatment. A one-SD increase in the fraction of

the management company’s outsourced assets reduces the four-factor αof the

outsourced funds by 1.44% per year, significant at the 5% level.

Building on these findings, we test whether preferential treatment can be

viewed as a form of in-kind compensation that the family extends to the subad-