The investment management industry has benefited from a period of above average returns for over a decade.
This has counteracted the impact of negative net asset flows for many active managers. With central bank action, inflation and the broader impacts of the pandemic dominating the headlines from a macro perspective, most market commentators view more volatility and lower returns as the most probable scenario we will face in the coming years.
In such an environment, most investment managers will need to analyze their business even more closely and ensure they are operating at maximum efficiency levels. While the concept of outsourcing functions is not new within the industry, historically the idea of outsourcing trading is something that managers have viewed as suitable for start-ups, and not for established firms. This view is now being challenged as there are examples of small, mid-sized and larger managers (up to $50bn) that have successfully transitioned to an outsourced trading model in some form.
The form that Outsourced trading takes is unique to each manager’s situation. It is not a one size fits all solution as investment managers have different approaches to investing be it from their trading style, the geographic footprint of the strategies they manage, the asset classes they invest in, their client bases etc.
As managers think about outsourced trading, they could view it more as a supplemental solution to ensure they have redundancy built into their process and do not need to hire an additional trader, or they could outsource part of their book e.g., their non-U.S. trading. For others, a transition from a legacy model to a fully outsourced model may work best.
Over the course of this series of papers, we will look at why investment managers are considering outsourcing trading, historic objections that investment managers have had and how they overcame them. Lastly, we will look at how SMA/Wrap assets trading can be successfully scaled using unique Outsourced Trading solutions.
Part 2 – Reasons to Outsource
In the second part of our series on Outsourced Trading, we will look at reasons why investment firms may wish to consider outsourced trading in the current environment.
Investment managers need to optimize their operations
As we discussed in our first paper, the macro environment for active management means that most investment firms need to better optimize their operations and focus their expenditures on core areas of the business. We would argue that the core areas for asset managers are where alpha is generated (the investment team), and where growth and client retention is the focus (the distribution team).
While some will think that outsourcing a trader may only reduce salary spend, there are other areas of potential cost savings including:
• Bloomberg terminals
• SWIFT licensing and transactions
• OMS licenses
• Market data feeds
• Transaction Cost Analysis
• Hardware
• Office furniture and space
• Business continuity
• Future technology investment in trading
In addition, there are considerable time savings for investment firms no longer needing to manage the operational environment for the trading desk.
Trading has changed
Central to the discussion is a recognition that the role of a trader has changed over the years given the increasing fragmentation of liquidity and technological advances in the level and types of trading platforms. The role has also been impacted by the regulatory landscape and increased administrative demands being placed on traders.
In addition, equity markets, in particular, have become much more efficient and the evidence of alpha being created by trading inhouse versus outsourcing is not there in most cases anymore.
People
We find that most firms with a legacy trading desk have built in redundancies to ensure sufficient coverage on the desk during vacations, illness etc. We believe that firms that wish to retain an inhouse trading function could hire an outsourced firm to act as that back-up when required. This is one way in which firms can outsourced in a supplemental manner.
In addition, the Great Resignation phenomenon is something that we are seeing across all industries as more than three million people have left the workforce since the start of the pandemic. Investment firms are not immune to this. Should firms experience departures within their trading teams, it is often an opportune time to investigate outsourced trading rather than automatically seek to hire a replacement.
Product development
Many investment firms look to expand their product offerings either organically or inorganically. These expansions often result in the need for additional trading needs. A good example of this is when a manager focused on domestic equities decides to launch a non-U.S. equity strategy. Rather than look to add resources or have team members working “night shifts”, outsourced trading may be a logical avenue to cover non-U.S. trading needs. This is another example of where outsourced trading is viewed as supplemental to the firm’s existing trading desk.
After reading this, some of you will think of objections to the idea. In the next part of our series, we will examine the typical objections we hear, and more importantly, how they can be overcome.
Part 3 – Objections to Outsourcing
In part 2 of our series, we discussed the reasons why investment managers may wish to consider outsourced trading. In this paper, we will look at the common objections we hear from investment firms and the areas they should focus their due diligence on as they assess outsourced trading providers. Business structure conflicts of interest and execution capabilities
We believe that it is imperative that investment managers investigate potential conflicts of interest fully. While there are a significant number of firms offering outsourced trading capabilities today, we believe managers should focus their due diligence on agency only firms that do not engage in proprietary trading or investment banking activities.
It is critical that your outsourced partner is unconflicted in terms of flow. Attention should be paid to ensuring that there are no internally developed algorithms, ownership of any trading pools, or pledges to any pools that could introduce potential conflicts of interest.
Strong consideration also needs to be given to the breath of trading venues utilized across algo suites, ECNs, ATS’, dark pools, and market makers
Best execution
First and foremost, investment firms are paid to act in a client’s best interest and maximize investment returns. Ensuring best execution in trading is a fundamental part of this.
We do not believe that best execution should be a concern given the size, scale and expertise of many outsourced providers, the breath and quality of their execution capabilities and ability to effectively report on best execution. In fact, we believe that the underlying clients of investment firms will benefit from improved execution.
As part of any move to an outsourced trading model, it is key to determine how best execution will be measured independently through third party Transaction Cost Analysis.
Confidentiality and Anonymity
Implementation of an investment manager’s strategy in a confidential and discreet trading manner is generally very important. This is built into the outsourced trading relationship as the outsourced provider is trading in its own name with no disclosure of the underlying manager’s (or client’s) name/s.
Proximity
Historically, portfolio managers have viewed the proximity of their trading team to be important. Working from home during the pandemic has changed the view of many as they have found they can work remotely while maintaining strong levels of communication.
Human element
Deciding to move to an outsourced model, particularly a fully outsourced model, will likely lead to personnel departures. We do believe that retaining one member of the trading team to manage the outsourced relationship may make sense for some firms if the person’s time can be maximized with other responsibilities. We have seen examples where the person who is retained can take on further vendor analysis/management responsibilities in areas that effect the investment team. We believe over time that this will become more important as firms increasingly look at ways that investment management focused fintechs can help their businesses.
Should a firm decide to outsource trading, we believe it is important that the portfolio managers are comfortable with the change and that they build strong relationships with their assigned trader/s at the outsourced firm. We believe it is best practice for the portfolio managers to be involved in the selection process of an assigned trader at the outsourced firm.
Another potential model is where an existing trader at the investment manager moves to the outsourced firm and becomes the assigned trader for their old firm. The potential for this will obviously be dependent on the economics of the trading business the outsourced firm is taking on.
Client perception
Investment managers worry about communicating any type of change to clients and consultants. Our experience over the past number of years is that outsourced trading has become mainstream, and clients and consultants are comfortable with the move if investment managers can demonstrate the due diligence they did in selecting an outsourced firm, how they will manage the outsourced relationship and evidence of best execution not being impacted.
Client type
While many investment firms will get comfortable with outsourcing trading of institutional separate account and commingled funds, they believe that the effective outsourcing of SMA/Wrap accounts is not possible.
This is a topic that deserves detailed analysis, and we will discuss it in more detail in the fourth and final part of our series.
Part 4 – Outsourced Trading for Wrap and Separately Managed Accounts (SMA)
In part 3 of our series, we discussed some of the common concerns investment managers have in terms of outsourced trading and how those concerns can be allayed. In this final part of our series, we will look at one specific challenge that managers face when considering outsourced trading – how outsourced trading can be effectively implemented for Wrap and SMAs.
An overview of Wrap and SMAs
Wrap and SMA accounts continue to be a very important offering in the marketplace with combined AUM in the United Stated of approximately $9 trillion as of need date and source.
Both vehicles facilitate individuals that require a more customized approach and those that wish to solely own securities rather than units of a mutual fund or other fund vehicle. They can also be used to allow more effective tax management for High-Net-Worth investors.
While the terms are often used interchangeably, there is a difference. With a Wrap account, a financial advisor may serve as the account’s investment manager, selecting individual securities or mutual funds. With an SMA, a financial advisor will use a separate money manager to manage the assets. In this paper we will focus on the latter and use the term SMA. However, regardless of whether assets are managed in either format, it is well known that the administration around trading is problematic for most firms.
It is also an area of regulatory focus and where investment managers that offer SMAs need to ensure that their practices act in the best interests of their client as well as having disclosures that provide the necessary transparency to investors.
Trading of SMAs
When managing SMAs many investment managers trade away or step out allowing them to execute a trade through a broker or dealer other than through the program sponsor. However, most mangers still employ rotation among the SMA sponsor programs they are part of and their institutional separately managed accounts.
In practice, executing brokers, in most cases, cannot aggregate institutional orders with trade away orders while including a markup/down on the wrap allocations and a commission on the institutional accounts. It is either charge a commission on the institutional allocation and step out the trade away with no compensation or settle all allocations at a net price.
Outsourced trading of SMAs
For firms considering a move to outsourced trading, there are challenges to consider when they manage both accounts for institutional investors as well as in SMA format as aggregation, allocation and settlement becomes more difficult when considering outsourcing trading.
However, while not widely used at this time, there are tools available that can help investment managers mitigate these aggregation, allocation, and settlement problems.
Investment managers can meet their best execution responsibilities, trade all orders (institutional and SMA) within a single block while simplifying their operations. By trading in this way, it should allow managers to reduce market impact and limit return dispersion among accounts managed in the same investment strategy across different sponsor platforms.
As part of this process, there is a need for investment managers to outsource this operational component. This should fit with the stated objective of many managers to outsource non-core functions.
As the outsourced trading market continues to develop, we expect that additional tools will become more widely used to allow for the effective outsourcing of SMA accounts while reducing the administration burden with the settlement, clearing, and disclosure processes.
Review
Over the course of our 4-part series, we have looked to analyze the development of outsourced trading in recent years and how investment managers can benefit from considering a move to an outsourced model. We expect the growth in the industry to accelerate in the coming years with investment managers being able to customize the outsourced model that fits with their business.
This paper was written by Martin Coughlan of Acclinate. Martin is a CFA, CAIA. He spent over twenty years working at asset management firms globally. He has experience across the investment, distribution and operations functions. As a member of executive committees at three different asset managers, he is very much attuned to the challenges and opportunities that the buy-side faces. He has been involved in a number of outsourced trading implementations at investment firms that previously employed legacy trading desks.
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