Contributed by Chris Hurley and Robert McHeffey, Capital Institutional Services, Inc.
The ‘outsource vs. avoidable expenditure’ decision by investment managers and selection of outsource partners are often pivotal for business growth and scalability. As investors continue to allocate to those managers that have reliable and institutional grade infrastructure, outsourced trading helps attain that goal without bearing the costs.
A 2017 white paper published by Blue River Partners and Eaton Partners summarized:
“As the asset management industry continues to change-whether due to increased regulation, innovation of investment strategies or ever-increasing expenses-managers have sought new approaches to adapt to a changing marketplace. Increasingly, managers have turned to outsourcing critical business functions as a cost-effective and high-quality alternative to more traditional in-house structures. In light of our observations and current market data on the current state of the industry, we believe the outsourcing trend is here to stay.”
Greenwich Associates outlines in a 2018 study the diversity of offerings from outsourced trading firms and identifies the reasons that buy-side market participants are adopting these services in growing numbers. Additionally, the study found high levels of satisfaction among those currently employing outsourced trading services, with 100% of respondents saying they are “satisfied” with their providers, and an astonishing 71% were “extremely satisfied”:
“Managing an equity trading desk has become increasingly complex for institutional asset managers. The execution process itself has become more complicated, with liquidity fragmented across dozens of venues… (costs are rising), leaving little room for institutional trading desks to increase headcount and/or resources. For these reasons, many asset managers are turning to outsourced-trading desks to help them manage some or all of their workload, gain access to international markets or new asset classes, reduce costs and expand their broker networks.”
Large asset managers are increasingly following in their smaller peers’ footsteps, looking to outsource trading operations to cut costs. New research from consultancy Opimas estimates 20% of managers with over $50 billion will outsource at least some of their operations by 2022:
“The future for outsourced trading desks looks bright and, in coming years, we expect an increasing number of even large asset managers will move to at least hybrid trading desks, with some portion of their trading activities outsourced . This will typically be for asset classes where the fund managers have insufficient scale to justify the cost of full-time traders. Most frequently, this will involve foreign equities in different time zones, where staffing becomes problematic.
On the smaller end of the scale, asset managers with more limited assets under management will continue to rely on third parties for their trade execution, but they will be more reluctant to add full-time staff, even as their assets grow. This means that the threshold in terms of trading volumes where smaller asset managers start to consider creating their own trading desk will increase. As a result, providers of outsourced trading services are seeing their activities grow rapidly, with revenues increasing for many of them at rates of 20 to 30% annually. The headwinds the asset management industry is facing now will continue for the foreseeable future, which is a boon for these providers.”
“Buy-side traders are expensive to hire and require significant investments in market data, order and execution management systems, and connectivity to broker-dealer and execution venues, in addition to their salaries and bonuses. Rapidly, the total cost of the initial buy-side trader can exceed US$500,000 annually when all of these costs are factored in.”
A recent survey of Traders Magazine readers, representing a broad spectrum of buy-and sell-side professionals, found that 28% work for firms that have either already outsourced some of their trading and back-office operations or are actively considering doing so. That may not sound like a big number but given outsourced trading’s longstanding reputation as a niche service for hedge funds only, it qualifies as a significant figure.
Some of the criteria that asset managers looking at outsourcing should consider include the following:
• Regional coverage
• Instrument coverage
• Number of traders, experience in instrument class
• Number of similar clients
• Number of connections to relevant brokers and execution venues
• Systems architecture, including review of the order management and execution management systems in place
• System used for transaction cost analysis
• Review of historical execution quality
• Commission management program
• Trade allocation policy
• Any conflicts that the provider may have, including proprietary trading or asset management