Sub-Advisors Are In The House

October 1, 2006 Alan Lavine

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.