We investigate the eect of compensation contracts on the conditional risk choice of outsourced mutual funds. Unlike the results from the existing literature, outsourced funds display two times more 'strategic' risk-shifting than in-house managed funds to maximize the value of payos. We further establish that compensation contracts, along with outsourcing status, have a causal eect on risk-shifting. As a next step, we hand-collect the data from the Statement of Additional Information to capture the cross-sectional variation in the compensation types for in-house managed vs. outsourced funds subsamples. Surprisingly, outsourced funds with 'asymmetric' performance-based bonus contracts do not display more risk-shifting behavior than non-performance-based outsourced funds. In contrast, their in-house counterparts with corresponding contracts engage signi cantly more in strategic risk-shifting. This behavior of outsourced managers is more consistent with a motive to manage the risk of the advisory contract getting terminated and less with the motive to exploit the optionality in the asymmetric compensation contracts of fund managers. To explain the impact of contract termination on the risk-shifting decision, we use the heterogeneity in the scale and scope of external advisors' operations. More established advisors who manage assets for a host of clients engage in less risk-shifting. Lastly, fund families can (i) hire multiple external advisors simultaneously (comanagement), (ii) hire external advisors that are geographically closer (co-location), and (iii) invoke the reputation of the external advisor while marketing the fund (co-branding) to curb the excessive risk-shifting behavior of the outsourced managers.
