The debate over using in-house or outside fund
managers focuses on cost and effectiveness.
Which is the better choice for client money,
sub-advised mutual funds or funds managed in-house by the investment
company?
A thorough analysis comparing performance and risk- adjusted statistics
of in-house and sub-advised funds is necessary, because sub-advised
funds, as a group, have a mixed track record over time.
Sub-advised mutual funds have been increasing in
popularity. Yet a recent study by the Financial Research Corp. (FRC),
Boston, found little difference in performance between sub-advised
funds and in-house managed funds.
Over the past five years, sub-advised funds slightly
underperformed in-house funds. But over the past one-year and
three-year periods, sub-advised funds slightly outpaced in-house funds.
Domestic sub-advised mutual funds have
underperformed in-house funds by less than 50 basis points in annual
return over the past five years ending in May 2006, FRC says. Over the
past one-year and three-year periods, however, sub-advised funds
outperformed in-house funds by more than one percentage point in annual
return.
Past research tells a different story. Sub-advised
funds outperformed in-house funds by 83 basis points in annual return
for the five years ending in 2000, FRC says.
"There is not a huge difference in returns," says
Chris Sporcic, research analyst with FRC. "It could be random chance."
On the overseas side, however, sub-advised funds underperformed
dramatically, he says. Asia Pacific mutual funds earned 973 basis
points in annual return less than in-house funds over the past five
years.
Sporcic says many institutions and financial
advisors favor sub-advised funds because they can hire the best
managers and not rely on in-house staff. Currently 13% of mutual funds
are managed by outside advisors. And assets in sub-advised funds have
increase 25% to $755 billion since 2004. By contrast, assets of all
mutual funds are up about 15%, or $453 billion, over the same period.
Financial advisors and analysts may be familiar with
the largest players in the sub-advisory marketplace. They include
Wellington Asset Management, Alliance Bernstein, PIMCO and Prime Cap.
But there are a number of smaller shops with strong track records. The
brand name of the sub-advisor is not an important issue today.
"There's been a move in the industry shifting away
from brand names," Sporcic says. "In the past, funds were chosen based
on the brand name, not on expertise. Now financial advisors and
institutions look at performance and the best product." At the top of
the list are outside advisors, such as GMO and Acadian Asset
Management, he adds.
Institutional investors, particularly, are looking
for money managers. Matthew Grove, chief marketing officer for
Jefferson National Life Insurance Company in Dallas, says his company
is considering adding sub-advised funds to its Monument Advisor
no-load, no-surrender-fee variable annuity. Currently, the annuity
offers 154 brand-name mutual funds representing 24 mutual fund
families, like PIMCO, Third Avenue, Rydex and American Century.
The main reasons Jefferson National is on the hunt for sub-advisors are:
Some money managers, typically only available to
institutional investors, have better track records than many brand-name
mutual fund managers.
Jefferson National would have more control in adding or removing sub-advised funds from the annuity.
The cost of sub-advised funds is lower than
third-party funds due to the legal structure of putting mutual funds in
a variable annuity's separate account trust. As a result, investors'
expenses are lower.
Other institutions, however, are moving some of
their money in-house. For example, Hartford Mutual Funds introduced new
small-cap and mid-cap stock funds offered by Hartford Investment
Management Co. because Wellington Management, which sub-advises a
number of Hartford's funds, has reached its capacity in managing
small-company stocks.
Overall, sub-advised funds are in vogue. Sub-advised
mutual funds allow small investors access to firms that may require
initial investments of several million dollars, according to Sporcic.
For example, John Hancock offers ten funds run by GMO, he says. Acadian
Asset Management runs funds for ING, Phoenix and Vanguard.
There often is turnover with investment company
sub-advisors. For example: The Accessor International Equity Fund axed
J. P. Morgan Asset Management and hired Pictet Asset Management in
2005. SEI switched to smaller, London-based Ashmore Investment
Management from Citigroup Asset Management to help run its Emerging
Markets Equity Fund in October 2005.
Although sub-advised funds are more popular, it's no
sure thing that a sub-advised fund will outperform its peers.
As a group, the AXA Enterprise Mutual Funds, a
stable of 30 sub-advised equity and bond funds, have underperformed the
category average. The investment company's funds outperformed the
category average only in 2002 and this year, through July, according to
Morningstar Inc.
By contrast, the Masters' Mutual Funds group of four funds has
outperformed the category average every year from 2002 through July
2006. Each fund has several highly regarded sub-advisors from other
mutual fund shops.
The Masters' Select Equity Fund, a large-cap blend
fund, invests in the best picks of stellar managers, such as Bill
Miller of Legg Mason, Chris Davis of Davis Select Advisors and Mason
Hawkins of Southeastern Asset Management. The fund has outperformed the
S&P 500 over the five years ending in July 2006.
Although sub-advisors are popular, there is no free
lunch. Fund groups that typically use sub-advisors say they have to
change sub-advisors about two-thirds of the time because portfolio
managers leave their jobs or underperform due to poor stock picking.
Christine Benz, Morningstar's director of fund analysis, says due
diligence is the key to picking client funds. Financial advisors can't
just put money into funds based on past performance.
"It's a mixed bag," she says. "In general I am a fan
of sub-advised funds. The management company and the board have to look
across fund shops for the best asset managers. In theory you should end
up with better caliber of managers."
But why aren't the returns of outside advised funds
overpowering in-house funds? Sporcic says expenses are one reason a
sub-advised fund may underperform a comparable in-house managed fund.
The average sub-advised U.S. stock fund sports an expense ratio of 116
basis points. By contrast, in-house fund expenses average 107 basis
points. On the international side, however, sub-advised fund expenses
are significantly higher than expenses for in-house funds.
Another issue is: Could side-by-side management of a
fund group's retail funds impact performance of sub-advised funds?
After all, research already has indicated that the
performance of investment company retail mutual funds suffers when the
firm also manages hedge funds.
Over the ten years ending in 2004, 457 mutual funds
run by firms that managed hedge funds underperformed similar mutual
funds, reports Scott Gibson, associate finance professor a the College
of William and Mary Mason Business School. His study suggested that
investment companies devote more expertise to the hedge funds because
they earn higher fees.
However Benz of Morningstar doesn't think the
side-by-side management of in-house and sub-advised funds detracts from
the performance of either type of managed fund. The in-house and
sub-advised funds have different investment guidelines, even though
they may be similar. The sub-advised funds offer the stock picking
expertise of the portfolio managers. For example, Brian W. H. Berghuis,
manager of the T. Rowe Price Mid-Cap Growth Fund, also manages a number
of sub-advised funds, she says. His sub-advised funds are not the same
as T. Rowe Price's brand-name fund. But those funds have excellent
track records.
The bottom line: Financial advisors must identify
the best funds regardless of whether they use in-house or outside money
managers, Benz says. Some criteria to consider include comparing fund
returns to a specifically defined benchmark, not just the S&P 500.
Funds should be compared with other funds with similar holdings.
Performance should be monitored closely. And if a fund underperforms,
financial advisors should find out why.