The COVID-19 pandemic is adding fuel to the fire of interest from some fund management firms in outsourcing the execution of their trade orders to third-party specialists.
Over the past few years, fund managers have decided that outsourcing isn’t only for middle and back-office functions. It can also be used for trade execution with cost reductions coming from the provider’s scale and expertise coming from more skilled traders who have previously worked in sell-side firms. The COVID-19 pandemic simply added at least two more immediate factors to the decision-making process for what has been called the third-wave of outsourcing– disaster recovery and acceptance of working from home. “The what-if scenarios have become significant and this pandemic has forced investment managers to evaluate their business continuity plans. Buy-side traders could easily become sick or unavailable,” says Packy Jones, executive chairman of JonesTrading, a Westlake Village, California-headquartered broker-dealer offering outsourced trading services. “Portfolio managers also realize they don’t have to be working in the same office as their traders to be successful.”
As if the growth of exchange-traded funds, passive investment strategies, and low-cost strategies weren’t hard enough to squeeze most fund managers’ profits, the pandemic has made it even harder for them to retain their thin margins while fulfilling regulatory requirements. “The implicit cost of trading has risen substantially during the pandemic as market volatility rose and access to liquidity became difficult,” explains Tim O’Halloran, managing director of Stamford, Connecticut-headquartered broker-dealer Tourmaline Partners, which also offers outsourced trading services. Having access to more pools of liquidity than the average buy-side trading firm, service providers can help fund managers meet their “best-execution” obligations for orders to be executed at the lowest total cost — implicit and explicit. Implicit costs are higher to calculate than explicit, which are the actual brokerage fees for trade execution. Implicit costs include the bid-ask spread, market impact, and arrival cost or the difference in the price of the shares from the time the order was placed by the client to the time it was executed.
For outsourced trade execution service providers, the once-in-a-lifetime market scenario has created a financial bonanza by increasing revenues at least 40 percent in some cases to over 100 percent in others for the first six months of 2020 compared to the year-ago period. Tourmaline tells FinOps Report that it has nabbed fifty new clients this year while JonesTrading says it has onboarded five and INTL Fillmore Advisors LLC says it has won four. Newcomer Amundi Asset Management, a European fund manager, tells the publication “The Trade UK” it has nabbed seven clients. US fund managers continue to lead the charge for using external service providers and based on the pipeline of interest the cottage industry of service providers will be singing all the way to the bank for some time.
Of the trade operations managers at ten US fund management firms contacted by FinOps Report which do not rely on an outsourced or supplemental trading desk, seven say that the pandemic has reinforced the need to enhance their disaster recovery plans with a trader ready to step in during an emergency. The remaining three fund managers say they are re-evaluating their costs and will consider either an outsourced or supplemental trading model within the next year. Of those three, two say they would implement supplemental trading for equity transactions in Asia-Pacific-based firms. Paris-based consultancy Opimas predicts that even if the outsourcing boom eases as the buy-side adapts to trading from home, at least 20 percent of fund managers with over US$50 billion in assets will outsource part of their business over the next few years.
Outsourced trading providers serve as middlemen between the buy-side and sell-side in handling order flows, but their goal is to mimic the buy-side trading desk in terms of how they interact with clients. The fund manager has a single relationship with the outsourced trading provider, which in turn has relationships with multiple other brokers and trading venues. In some cases, the fund manager is the disclosed counterparty while in others it is anonymous. The trade execution provider will also replicate the fund manager’s technology in order management systems, trade execution management systems, direct market access, compliance platforms, customized algorithms, and pre-and post-trade cost analysis. The result is the creation of an entire enterprise apart from the portfolio management desk, which deals in high-level investment strategies.
There are two main flavors of outsourcing to choose from: the fully outsourced model and the supplemental or hybrid model. In the fully-outsourced model, the service provider takes over all of the trade execution requirements while in the supplemental or hybrid model only part of the trading desk is taken over or rather it is added. The idea behind the supplemental or hybrid model is that the buy-side can access foreign geographies when its internal traders may be fast asleep; access parts of the liquidity spectrum outside of the internal desk’s reach, or deal with difficult transactions that require anonymity for minimal market impact and to preserve alpha.
The outsourced model also has variations depending on the level of customer service. JonesTrading, for one, says that its most recent area of focus is business continuity where the firm backs up an internal trading desk handling a fully redundant trading solution to seamlessly execute orders upon any business interruption. Its fully-outsourced trading desk outsources all trading and middle office services with a dedicated trading team. Its enterprise-outsourced service model, which represents a twist on the fully-outsourced model, in adding sponsored technology and potentially a co-located dedicated trader in the client’s office. The supplemental model — which JonesTrading calls the regional focused outsourced model — allows Jones to handle “non-focus” regional trading for clients.
Trade execution service providers fall under one of four categories: so-called independent firms that have no parent; firms that are part of larger conglomerates offering agency brokerage and prime brokerage; custodian banks; and fund managers themselves. Tourmaline Partners, JonesTrading, Cowen, Jefferies, INTL Fillmore, State Street, and Northern Trust are among several dozen players. Formerly an independent outsourced trading provider Fillmore Advisors was bought by brokerage and clearing firm INTL FC Stone, now called Stone X Group, in 2019. In April 2020 Amundi struck a deal with Luxembourg-based custodian Caceis to help rollout Amundi’s outsourced trading service to other fund managers integrating Amundi’s front end platform ALTO with Caceis’ middle and back -office services. State Street is leveraging its 2018 acquisition of order management platform operator Charles River Development for its offering.
While all of the outsourced trading service providers perform similar tasks, those in the independent category insist their “pure-play” position makes them the best choice. “We are independent and agnostic and do not compete with the sell-side in its core business of research, banking and prime brokerage. This provides us with an unconflicted robust path to liquidity.” asserts Tourmaline’s O’Halloran in a recent webinar moderated by FinOps Report. “We are positioned as a buy-side firm and we are a large client to the sell-side with our scale and global reach allowing us to provide custom solutions for many clients seeking to expand their access to liquidity and information flow.” Yet even service providers, such as INTL Fillmore which operate under the umbrella of a larger parent tout their neutrality. “We are agnostic on trade execution and send the majority of our orders to other banks and brokerage firms,” says Andrew Caplan, head of outsourced trading for INTL Fillmore in New York. Custodian banks, for their part, are hopeful they can use their relationships in safekeeping and asset-servicing to win over fund manager clients for trade execution services, but their rivals counter that they fall flat when it comes to expertise in trading.
Is outsourcing the trading desk for everyone? As a rule of thumb, the larger the value of assets under management, the lower the cost savings for fully-outsourced trading. However, service providers insist there is plenty of interest from fund managers of all sizes. “While the idea was initially embraced by smaller fund managers– particularly hedge funds– larger fund managers are starting to show interest as they become more savvy about costs,” says Caplan. “All fund managers are asking themselves do I need a fancy office with traders and the answer during the pandemic is no.” Outsourced trading desks can absorb some of that cost and personnel.” It is impossible to predict how much a fund manager could save through a fully outsourced trading operation as it is directly related to trading frequency and region of trading. However, what is certain is that the outsourced model converts the fixed overhead of trading operation into a variable cost related to trading frequency.
Cost reductions aside, third-party trade execution service providers can also address a cumbersome compliance task of commission management in meeting the rules of the second incarnation of the Market in Financial Instruments Directive (MiFID II) for European fund managers. Until recently European fund management firms didn’t have to disclose how much money they spent on trade execution and research separately. MiFID II has now required unbundling. “Among the many requirements of MiFID II was a new research payment protocol through RPAs [research payment accounts] and a demand for transparency regarding the costs of both research and trade execution,” explains Andrew Walton, director of European business for Tourmaline, in its recent webinar with FinOps Report. “However, we now see that the EU recommended some of these requirements be walked back, suggesting a rebundling of small cap and FICC research.” Although these recommendations may take time to be resolved, he believes, that investment managers and asset owners will still demand transparency, sound capital governance, and conflict-free solutions. Few fund managers are willing to pay for research out of their own pockets. Service providers offering sophisticated commission management platforms that can address variations of commission sharing agreements, such as Tourmaline, will set themselves apart from the pack, says Walton.
Despite the benefits of outsourced trading there are still plenty of skeptics. Some fund managers are fearful they will lose intangible benefits such as market insight and critical relationships with customers which will eventually eclipse cost reductions. Others say that best-execution isn’t always guaranteed and performance results could be lower than those of the internal trading desk. Some fund managers are even worried about how they will explain the expense to their fund clients which will bear the costs. Unlike trade execution fees which are included in management fees, the fees for outsourced trading are paid by the fund and ultimately fund investors. Service providers are naturally quick to dispel any concerns. They counter that fund management firms benefit from potentially higher investment returns generated from outsourced trading which override the potential costs to investors; however, none can provide comparable figures from internal trading teams and third-party outsourced trading providers. Outsourced trading is also limited to equities, reflecting the different nature of fixed-income securities. Unlike equities which represent one asset class, fixed-income securities have multiple subcategories. “Adding real value to trade fixed-income on an outsourced or supplemental manner will require a significant capital commitment to have scale on day one,” says Walton. “Simply putting a single fixed-income trader in a chair won’ suffice.”
Whether the fund manager decides to rely on a fully outsourced model or a hybrid supplemental model ultimately less relevant than the decision to actually allow a third-party into the trade execution process. Fund managers who spoke with FinOps Report predict that the percentage of fund managers interested in some version of outsourcing could easily rise to 30 percent because of the pandemic. “The pandemic has validated the business model of outsourcing,” says Jones of JonesTrading.
Outsourcing trade execution may not be every fund manager’s cup of tea, but at the very least as Shane Swanson, an analyst with research firm Greenwich Associates in Greenwich, Connecticut says “It is another quiver in the buy-side’s arrow to help make sense of this mad,mad world.” Once hesitant over the idea of relinquishing control of trading to a third party, fund managers are understanding it can mean the difference between success and failure during unprecedented market conditions.