It's very feasable to do it with an external drive.
Make sure it's FAT32 not NTFS. I made that mistake once.
I'm pretty sure that video files stored on internal/external HDD cannot use the same upscaling method the DVD player in the PS3 uses.
Best PQ: stick the DVD in (unless I test otherwise)
But, I've had good luck so far with Anime being on disk. PQ is good, but some discs that I've transfered to MPEG-2 have a bit of issue with bob/weave. It's hit or miss on my end, I just hate having to put discs in when I want to watch Anime.
Keep in mind, most of my Anime is 30 Minutes long per episode; a long continuous movie might be a problem.
Singular files have to be under 4GB.
Clusters cannot be 64 kilobytes (KB) or larger. If clusters are 64 KB or larger, some programs (such as Setup programs) may incorrectly calculate disk space.
A FAT32 volume must contain a minimum of 65,527 clusters. You cannot increase the cluster size on a volume that uses the FAT32 file system so that it contains fewer than 65,527 clusters.
The maximum disk size is approximately 8 terabytes when you take into account the following variables: The maximum possible number of clusters on a FAT32 volume is 268,435,445, and there is a maximum of 32 KB per cluster, along with the space required for the file allocation table (FAT).
You cannot decrease the cluster size on a FAT32 volume so that the size of the FAT is larger than 16 megabytes (MB) minus 64 KB.
You cannot format a volume larger than 32 gigabytes (GB) in size using the FAT32 file system during the Windows XP installation process. Windows XP can mount and support FAT32 volumes larger than 32 GB (subject to the other limits), but you cannot create a FAT32 volume larger than 32 GB by using the Format tool during Setup. If you need to format a volume that is larger than 32 GB, use the NTFS file system to format it. Another option is to start from a Microsoft Windows 98 or Microsoft Windows Millennium Edition (Me) Startup disk and use the Format tool included on the disk.