Choosing between types of financial advisors like external or internal ones ultimately depends on the needs of the investment firm and the kinds of objectives the fund is meant to achieve. Both types have their advantages and disadvantages.
Importance of a Financial Advisor
When distinguishing between types of financial advisors, whilst the importance of a financial advisor is generally recognized, the significance of a mutual fund’s organizational and administrative framework is generally forgotten. One of the most forgotten issues in mutual fund evaluation is the effect that the organization of portfolio management has on performance.
Broadly speaking, the fund’s investment portfolio can be managed in one of two ways: contracting external advisors or administering it internally using staff who are an integral unit of the fund’s management.
Types of Financial Advisors
The chief rationale for using these types of financial advisors is that external advisors provide fund investors with access to the best available talent. When choosing a financial advisor, major pension funds and wealthy individuals seek out and hire the world’s best managers, the same way sports teams become winners by handpicking the top free agents.
A study found that the average ten-year compound return of 14 externally advised funds was 7.6%, while the average ten-year compound return of 46 funds advised in-house was 7.9%.
The chief limitation with this analysis is that there are some cases in which funds have used both in-house and external advisors during the ten-year period under review. That caveat aside, it seems reasonably clear that the difference in performance between the in-house funds and the contract funds is insignificant, and that contracting portfolio advice to outside advisors does not necessarily improve performance.
An external financial advisor has to contend with potential conflicts of interest. Typically, an external advisor has several funds as ‘clients’ and the same investment choices will often be suitable for more than one client. There will inevitably be conflicts about the allocation of such investments when they are available in only very limited quantities. The prospectus of funds employing external advisors often devotes considerable attention to explaining the way in which potential conflicts will be resolved, but the external advisor is frequently required to strike a less-than-ideal compromise.
Relative performance is not the only consideration in determining a fund’s management. One of the most important characteristics of good management is its stability. If a fund’s financial advisor group is constantly changing, its past performance is unreliable as a guide to future performance.
In our view, there is a much smaller likelihood that there will be dramatic or abrupt changes in the responsible personnel when the portfolio is advised internally. In many cases, these types of financial advisors responsible for portfolio investment were founders of the fund or fund group. Even if the short-term performance of their funds lag, it is unlikely that there will be wholesale changes in the investment group.
The same cannot be said of funds that employ external portfolio advisors. It is, quite simply, easier to sever a merely contractual relationship than it is to remove personnel who are an integral part of the fund’s organization. As a result, it is far more likely that relatively short-term under-performance will precipitate a change in advisors.
The difficulty with this attitude is that it fails to allow for the inherently cyclical character of portfolio management. Every portfolio manager has periods of both weakness and strength, but it is frequently possible to distinguish between cyclical variations and a more substantial deterioration in performance only by taking a long-term perspective. However, the relative ease with which an external financial advisor can be replaced does not encourage such a long-term outlook, and may result in the removal of the portfolio advisor from the fund just as its performance is about to improve. Even more damaging is the fact that the portfolio advisor assuming responsibility is often chosen because of their recent strong performance at some other fund. Almost inevitably, this superior performance fades.
A fund’s comparatively low level of commitment to external advisors is often matched by the attitude of the external advisors. Some general studies of management behaviour suggest that external management is less committed to the long-term success of an organization than internal managers. There is evidence that managers who do not have a stake in the organization are more likely to pursue strategies that put their own interests ahead of the organization’s interests. In the context of mutual funds, this may mean that external portfolio managers, who are more susceptible to abrupt removal, are more likely to pursue strategies emphasizing short-term performance in an effort to bolster their own positions and reputations. Internal portfolio advisors, with a vested interest in the viability of the fund, are more likely to pursue approaches that maximize long-term performance.
By using these types of financial advisors, external portfolio advisors enable the fund to acquire immediate access to expertise on distant regions that it would be slow and difficult to develop internally. However, by creating institutional rather than merely contractual links between the advisor and the fund manager, the lines of communication with the internal advisors of other funds in the group are strengthened and deepened. While it will unquestionably be more difficult to terminate such an advisor if the relationship does not work, the equity interest signifies that a long-term relationship is anticipated.