The buy side is going through a transformation that we have not seen in decades, driven by intensifying margin pressure. Increasingly, buy-side firms are looking to outsourced trading desks as a means of converting fixed in-house trading costs to variable commissions. As the diversity of outsourced trading providers and service options grow, however, managers searching for outsourced trading partners are often left with more questions than answers. TABB Group senior analyst Michael Mollemans examines the various outsourced trading service models available and the buy side’s biggest concerns associated with the use of outsourced trading services.
The decision to outsource trading usually is driven by a need to cut costs. But the arrangement is not without its challenges. Since buy-side traders are an integral part of the investment process, they need to be fully integrated with the investment management team. If the dynamic flow of information between the portfolio manager and an outsourced trader is not aligned, then the performance of the fund could suffer, driving clients to leave.
[For more on outsourced trading, check out part 2 of this article, "Outsourced Trading Goes Viral."]
Further, the typical workflow, duties and responsibilities of buy-side traders are quite different from sell-side traders. Outsourced traders are mandated to be an extension of the buy-side firm and so buy-side trading experience can be very helpful. In fact, buy-side firms often insist that their outsourced trader have buy-side experience so that they understand the unique responsibilities of the role, and this is among the service offerings most valued by managers (see Exhibits 1 and 2, below). Outsourced trading firms understand this point and often hire only traders with buy-side experience.
In addition, portfolio managers must feel as if they are a top-priority client for their outsourced trading partner. This generally is true for traditional sell-side brokers as well, but it takes on a much-elevated level of importance for outsourced trading firms because they are, in effect, competing with an in-house trading team that truly serves only one client – their own firm. If at any point a portfolio manager feels that his communication, requirements and instructions to the outsourced trader are competing with other firms and are not the sole priority of the outsourced firm, then a portfolio manager may be able to make a good case, based on the fiduciary responsibilities, that his firm’s interests are best served with an in-house trading desk, rather than an outsourced desk.
Night desk trading coverage is among the most popular segments of the trading operation to outsource. Emerging markets trading coverage is also a popular segment of the desk to outsource because of the complexity of trading in these markets and the relatively small percentage of assets under management invested in them. Backup trading coverage – when members of the core in-house trading team are on vacation or traveling, for example – is also a popular trading desk support function provided by outsourcing firms (see Exhibit 3, below).
Since the introduction of MiFID II, many buy-side firms have cut their broker lists significantly. Outsourced trading firms allow buy-side clients to have the best of both worlds by utilizing their outsourced traders’ extensive sell-side relationship network – often of as many as 30 to 300 brokers (see Exhibit 4, below) – which can come in handy when needing market color or one-off research reports in emerging markets or infrequently traded issues/difficult names. Portfolio managers recognize the information flow benefits that outsourced traders’ wide broker networks provide. Outsourced trading firms are seeing a surge in demand from buy-side firms that no longer have the broker access they once had but still want access to the local market information flow made available through an outsourced traders’ wide network. Through experience in dealing with their network of brokers, outsourced trading desks can provide a “smart broker router” service to clients, providing advice on which local broker is best able to provide one-off research reports or access to natural liquidity in a given name.
While hype is rampant around the business of outsourced trading, funds need to be very careful as they engage with outsourced trading desks. In-house traders are wary of information leakage with traditional brokers; the buy side must create the processes, procedures and guarantees to ensure that the manager and the outsourced desk are completely aligned. Not only does this mean measuring execution quality of the outsourced partner, it also requires establishing controls around information access and conflicts of interest, what the outsourced desk sees, how it engages with the market, and even what algorithms it uses. If investment performance suffers as a result of outsourcing trading, then any cost saving will be for naught. (see Exhibit 5, below)
For in-house traders, the firm is their only client and, thus, their sole priority. When a decision is made to use an external outsourced trading desk, there is often anxiety about where the manager stands in the pecking order versus all the other clients the outsourced traders are managing, as well as fear of information leakage, as the sharing of critical information can impact fund performance.
While outsourced desks represent that limiting these conflicts and leakage challenges is of paramount importance, it is still critical that buy-side firms implement procedures not only to limit the opportunity, but also to analyze trading performance for any hint of a challenge. Ultimately, both front-end trustworthiness and back-end verification are critical concerns, and the most important governance issues to manage when choosing an outsourced trading firm.
To learn more about the outsourced trading landscape and the buy side’s needs, please contact TABB Group for information on our most recent report, “Outsourced Trading, Part 1: Buy-Side Perspective,” by Michael Mollemans.