By Douglas Cumming, Armin Schwienbacher and Feng Zhan
What are the consequences of a mutual fund outsourcing different types of services: advisors, custodians, administrators, and transfer agents? A new study funded by the SWIFT Institute shows that mutual fund service outsourcing benefits investors – in terms of evidence of lower subscription fees, as well as some evidence pertaining to fund performance.
In a competitive market, firms face the choice of managing functions inside the firm or outsourcing some of these functions to external service providers. This is especially true in the mutual fund industry, and particularly when mutual fund managers are facing constraints on resources and opportunities (or capabilities) to undertake diversified portfolios globally. Managers in mutual fund companies are involved in a variety of functions: managing the fund on a daily basis, maintaining information related to the fund, providing investment and portfolio management advice, and calculating net asset value (NAV). Empirically, the authors observe that many of these functions have been outsourced to external service providers. An important question for both the practitioners and academics alike is whether or not outsourcing affects portfolio selection and thus has an impact on the fund’s operating risk and performance.
Based on principal-agent theory, outsourced funds could have either a higher or lower risk-return relationship. On the one hand, external services may oversee investment decisions more thoroughly, as there are no conflicts of interest with management, leading to more oversight with less risky portfolios. On the other hand, external services may oversee fund management less effectively compared with internal services, leading to less efficient monitoring and more risky portfolios. For example, the UK Financial Conduct Authority (FCA, 2013) has expressed such concerns regarding the “oversight risk” in the fund management industry. Eventually, this may impact the level of fees as more players get involved along the chain of operations, especially if outsourcing generates performance inefficiencies.
For the first time, the paper ‘The Scope of International Mutual Fund Outsourcing: Fees, Performance and Risk’ has examined the full scope of services that are outsourced, to administrators, transfer agents, custodians, advisors, trustees, and auditors, based on the LIPPER dataset. Based on over 13,000 mutual funds domiciled in Europe, this study shows outsourcing is very common; 12% of funds use external advisors, 41% use external administrators, 45% use external transfer agents, and 58% use external custodians, and all funds outsource to external trustees and auditors. These percentages are even higher for funds of independent management firms as compared to funds of bank-affiliated groups. In addition, this paper shows that outsourcing is less common among funds managed through banks, UCITS funds and institutional funds. For example, the results suggest that bank groups decrease the probability of outsourcing by 27-30%. More importantly, this paper shows that funds relying on outsourcing have different fee structures. Funds with outsourcing are more likely to have 11%-14% lower subscription fees relative to the overall average fees in the data.
Furthermore, this study finds mixed evidence on the performance implications associated with outsourcing. Outsourcing advisory services are associated with higher risk-adjusted performance (Sharpe ratios), while outsourcing of administrator, transfer agent, and custodian services are unrelated to risk. The association between outsourcing of advisory services and performance is more pronounced for funds belonging to a bank-managed group. The authors find that these results are somewhat sensitive to accounting for proxies of fund managers’ private information, as detailed in the paper.
Given the increased complexity in regulation, the implied cost of regulatory compliance and the economics of scale in the provision of services for mutual funds, one may expect the trend towards service outsourcing to increase further in the future. The results of the study indicate that most of the impact of this outsourcing is likely to be on fees, and less on operating risk and performance of funds. Instead, the latter is affected by outsourcing of advisory services. The study concludes that on average, fund managers efficiently react to outsourcing opportunities. The authors hope the analyses will help guide the decision to outsource and keep track of best practices in mutual fund outsourcing.
The authors’ of this article are completing their research paper, funded by the SWIFT Institute, which will be published in the coming weeks.
- Douglas Cumming – York University, Schulich School of Business
- Armin Schwienbacher – Université Lille 2 and SKEMA Business School, France
- Feng Zhan – Boler School of Business, John Carroll University
On 23 April Professor Armin Schwienbacher spoke at SWIFT’s annual Business Forum London. He was part of the panel discussion Outsourcing: The Shifting Dynamic.