Sub-advised fund assets grew by 9.1% last year, compared to internally managed funds, which actually dropped by 2.9%, according to a new study by Financial Research Corp. While sub-advised stock and bond funds account for only 10.1% of total industry assets, they drew in 16% of total net flows in 2000, according to FRC.

Several large fund families outsourced the management of some of their internally managed products, amounting to $11.1 billion in new assets for the sub-advised segment of the industry, according to FRC. For instance, Prudential outsourced 50% and PaineWebber outsourced almost 80% of its funds in 2000. "A lot of companies looked at their internal line-ups and were pretty unhappy with them," said Kunal Kapoor, a senior fund analyst at Morningstar. "Firms were trying to boost performance and take out the stigma of managing their own money. Brokerage companies, especially, have had a tough time developing their asset management business."

A Growing Movement

More than 14% of U.S equity funds use a sub-advisor and about 20% of international equity funds do. The movement towards sub-advisors may be due, in part, to the market volatility experienced in 2000, according to FRC.

"This is creating a new competitive landscape that is fundamentally changing the way mutual fund managers and distributors do business with one another," according to FRC's 2001 Sub-Advised Mutual Fund Report. "More and more distributors are realizing the need to offer Best-in-Class' performance to their investors through the employment of sub-advisors to manage some or all of their in house funds."

One result of that is a better overall product offering by the industry, according to John Benvenuto of FRC, one of the authors of the study. "Sub-advisory services have now entered the mainstream of the fund industry," said Benvenuto. "Asset managers are finding new ways to benefit from sub-advisory relationships both as providers of their own distinct management expertise, and as purchasers of the unique capabilities of other top managers. This is helping to rationalize the fund industry, improving the quality of product lines at a wide variety of families both large and small."

Employing a sub-advisor gives a firm not only investment management expertise, but also a great deal of flexibility, according to Ryan Tagal, an analyst at Cerulli Associates of Boston. It is much easier for companies to change the management of a fund due to poor performance if it uses a sub-advisor than if it uses in-house management, he said.

Although the growth of sub-advised funds grew dramatically in 2000, there had been steady growth in that segment for the past five years. From 1995 to 2000, sub-advised mutual fund assets grew an average of 27.4%, compared to 18.5% for internally managed funds, according to FRC.

The overall average expense ratio for sub-advised funds is 1.22%. That is about 14% higher than that of internally managed funds However, for the last five years, the average sub-advised U.S. equity fund has outperformed internally managed U.S. equity funds by an average of 73 basis points per year, which more than makes up for the disparity of management fees, according to the study.

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