Mutual fund families increasingly outsource the portfolio management task to external advisors. The high-powered incentive contract offered to external advisors, presumably an optimal outcome, implicitly creates convexity in their payoff. We provide causal evidence that this convexity makes the conditional portfolio choice of outsourced mutual funds about twice as risky as in-house funds, which leads to their underperformance. However, fund families can curb excessive risk-shifting unconditionally by: invoking the reputation of external advisor(s) when marketing the fund (co-branding) and hiring geographically proximate external advisors (co-location). Hiring multiple external advisors simultaneously (co-management) is also effective, specifically when underperforming.

Most mutual fund managers have performance‐based contracts. Our theory predicts that mutual fund managers with asymmetric contracts and mid‐year performance close to their announced benchmark increase their portfolio risk in the second part of the year. As predicted by our theory, performance deviation from the benchmark decreases risk‐shifting only for managers with performance contracts. Deviation from the benchmark dominates incentives from the flow‐performance relation, suggesting that risk‐shifting is motivated more by management contracts than by a tournament to capture flows.