We investigate the effects of contractual arrangements on the portfolio risk choice of outsourced mutual funds. Outsourced funds display two times more strategic risk-shifting than in-house managed funds. After instrumenting for a fund's outsourcing status, we further establish a causal relationship between outsourcing and strategic risk-shifting. Our evidence shows this behavior to be more consistent with a motive to manage the risk of contract termination and less with the motive to exploit the optionality in portfolio manager contracts. Fund families can employ additional mechanisms to mitigate the intrinsic risk-shifting behavior of the outsourced managers.

JEL classification: G11, G20, G23.

Keywords: Mutual fund, Outsourcing, Risk-shifting, Contracts​