Challenging the Stigmas of Outsourced Trading

Outsourced trading has turned mainstream over the past few years, starting as a niche service but now being adopted by asset managers of all varieties and sizes.  Despite the growing popularity, outsourcing is sometimes perceived as a recessionary business, more about cost savings or for asset managers that are smaller in scale.  Like other outsourcing trends, however, that stigma has been disproven over time. Asset managers that have moved to outsourced trading have experienced the realities of efficiency, flexibility, and transparency in their search for greater alpha.

By choosing to outsource a non-core function, asset managers can position their business for future growth by future proofing operations, streamlining efficiencies and enhancing returns. Additional services can be seamlessly integrated as well, including settlement oversight, automatic currency conversion to base currency, trade cost analytics, and commission management.  While outsourced trading can address the need for immediate and material cost savings, it comes with the potential to position firms for a more optimal, future state. Looked at in these terms, it can be presented as a positive, showing firms are focused on the future and looking forward to growth.

A recent survey conducted by Northern Trust of 300 heads of investment operations from global asset management firms, with assets ranging from US$10 billion to US$500 billion, reveals just how quickly operating models are shifting.¹ When asked to express their thoughts on outsourced trading, 85% of respondents said that they were already outsourcing trading or were interested in doing so. Given the sheer number of asset managers outsourcing part or all of their trading operations, many industry experts view it as the new normal.

Change is happening in the asset management industry faster than ever. Passive management and ETFs are ubiquitous. The younger generations have eschewed traditional investment advisor relationships and mutual funds. Regulation is rapidly evolving. Furthermore, the global pandemic has proven that portfolio managers and traders do not need to be physically co-located. As a consequence, asset managers of all sizes are re-thinking their current business operation with eye to find an optimal future state. As part of this process, the trading desk is under scrutiny: Is the trading desk critical in adding alpha? Does this function help us raise capital? Are the trading desks fully utilized? For many, it’s become hard to say that in-house trading desks are essential, and even harder to evidence any contribution to generating alpha. These firms are turning to the hyper-scale asset servicers which often perform these activities better than if they were kept in-house. Trading is a scale business, and the question is increasingly one of what’s likely to produce the best outcome.

In this sense, talent is not being displaced, it is being re-tooled. For example, the head of trading might find their role is redundant, but then find themselves in another role, as head of trading oversight. For whom better to have in that role but someone who knows it intimately? We believe this will be seen positively by regulators from a control perspective, and by asset managers and asset owners from a risk perspective and profit and loss perspective.

Some asset managers may fear that the years spent building relationships, know-how and expertise when trading in particular markets or instruments could be lost, which in turn might negatively impact client outcomes. Many outsourcing providers are sensitive to this and work hard to show clients that far from displacing this connectivity, they augment and often enhance their relationship to the street. This is achieved by clients leveraging global teams of highly experienced traders, many with buy-side experience, and with a broad array of relationships already well established. Added comfort comes from Trade Cost Analysis (“TCA”) that can measure trading performance.

In a non-outsourced model, when a market participant is selling something at the same time and same pace as another, the orders are unknowingly competing and creating excessive pressure on the stock price. The outsourced trader can better manage collective orders, splitting fills and managing overall market impact appropriately to avoid disrupting supply and demand in the marketplace. TCA reporting and regular governance meetings with the outsourced trader can also provide transparency and an effective feedback loop on trade management.

When an asset manager conducts their own trades, their activity is easier to decipher. Any time an asset manager presents a large buy or sell order to a broker-dealer, a signal is presented directly to the street that the asset manager is building or exiting a position. And broker-dealers will often reference regulatory filings, such as 13F reports in the U.S., to identify larger portfolio shifts. In an outsourced trading model, orders are mixed in with all other orders, thus no one on the street has any idea for whom the trades are being made. In addition, an outsourced trader can help disintermediate order flow. Finally, outsourced traders can provide TCA reports that provide price performance before, during, and after a trade is completed to constantly evaluate and look for the potential of information leakage.

An outsourced trading relationship must work in the long-term and a good provider provides an implementation process to fully support clients as they make the transition. The implementation should begin with a detailed discovery phase to fully understand the current trading touchpoints across all areas of the asset management firm - from the investment decision, compliance and risk, trade routing, reporting, and settlement. The outsourced trading providers should design an optimal future state and the service components for the relationship. This can help provide a seamless transition from a legacy desk to an outsourced trading provider and help ensure that there is no disruption to the client's investment process as a result.

Asset allocators and investment consultants are focused first and foremost on risk adjusted returns and fees. A strong case can be made that outsourced trading improves returns through greater scale and deeper expertise, reduced fees, and greater operating efficiencies. The benefits of outsourcing are significant, and investors recognize the value that results from improved technology, better governance, and heightened operational resilience.

Old assumptions about outsourcing have been challenged and, particularly during the pandemic, proven incorrect – a key example being the perceived need for proximity between portfolio manager and trader that work from home protocols have discredited. More widely, where outsourced trading had been seen as a defensive, reactive strategy, focus has now shifted to the variety of other benefits offered – including supporting risk management, streamlining operations, enhancing governance and improving operational and technological resiliency. Outsourced trading is increasingly a proactive and future focused decision and, as a result, many asset managers view it as a better way of doing things.

¹ Northern Trust. Northern Trust Survey: Asset Managers Most Concerned about Managing Rising Costs and Driving Bottom Line Performance amid Global Market Turmoil, 2020