Fund Managers: Outsourcing Trade Operations Not For Faint-Hearted

It’s become commonplace for fund managers to outsource middle and back-office operations.

After all, who wants to staff and oversee the labor-intensive work that comes after trade execution, especially if it can be contracted out to specialists? It’s commonly understood that this type of outsourcing can reduce operating costs, address regulatory compliance requirements, and most important, free asset managers to concentrate on their real business — making money for their investors.

What if fund managers took the same stance when it came to their trading operations? Wouldn’t that allow portfolio managers to come up with their brilliant investment ideas — aka which securities to buy and sell– and leave others to manage the details?

Apparently, a growing number of fund managers think so and are turning to either their custodians or specialist trade execution firms to operate on their behalf, according to a roundtable discussion recently hosted in London by popular order management system specialist Fidessa in London.

Of course, that doesn’t necessarily mean all fund managers will immediately fall in love with the idea. And even if they favor the move, it doesn’t necessarily mean they can pull off outsourcing trade operations. It’s a tough call to make and fund managers need to know just what they are getting into.

Five US and European fund management firms contacted by FinOps Report wouldn’t say whether or not they had already outsourced their trade operations or were even considering doing so. Apparently, the topic of discussion is a pretty sensitive one and rightly so. “It’s far easier to explain to investors why we are outsourcing our middle and back-office operations, but more difficult to explain that we need help with trading operations which is supposed to be part of our core offering,” one trading desk specialist told FinOps Report.

The reason: there are plenty of investors — and even portfolio managers and C-level executives — who think it’s just a part-time job which can and should be done internally. If fund management firms all want to claim they have the best portfolio managers money can buy and are marketing themselves as trade experts, they should certainly be able to handle the nitty-gritty of efficiently executing orders. How hard can that be?

What’s more, it should be considered an extension of trade allocation functions, and not a separate complex series of tasks, akin to post-trade processing work. Or so some believe.

Tough Job

That position couldn’t be further from the truth. Third-party service providers do a lot more than just execute orders. “They are replicating what would otherwise be a small or even large internal army of traders specializing in different asset classes and regions,” explains Steve Grob, the London-based group strategy director for Fidessa. “They are also providing the necessary technology to do so.”

Not only would fund managers need to hire trading specialists in diverse asset classes, but implement order management systems, trade execution management systems, direct market access and smart order routing platforms, compliance platforms, customized algorithms, as well as pre- and post-trade transaction cost analysis (TCA) tools to do the trick.

And that’s just for starters. Hopefully, front-office systems would be FIX-enabled as the FIX protocol has become a de facto requirement for trade execution. Then the fund managers would likely need to figure out how to clear and settle the trades.

If it sounds like an entire enterprise — separate from the portfolio management desk it is. “Portfolio managers come up with the high-level strategies, but expect traders to execute those strategies efficiently,” says Grob.

Fueling the drive for fund managers to even consider outsourcing their trading operations are cost concerns and the need to constantly keep up with market change. “It could end up being far less expensive to use a third-party trading operations as there are now so many venues to choose from,” explains Carl James, managing director of BNP Paribas Securities Services Dealing Services in the UK. The unit of the global custodian, which does not disclose its number of fund manager clients, offers outsourced trading operations for global equities and fixed-income assets from offices in London, Paris and Hong Kong.

What might have been just one or two or even a handful of exchanges to deal with in the European market has, subsequent to the adoption of the pan-European legislation MiFID in late 2007, turned into over a dozen venues — lit, semi-lit and dark pools. Navigating through them requires specialized expertise to prevent information leakage and ensure best execution; that is, the lowest overall costs taking into account the exact timing of the deal, the amount of shares to be traded, the algorithm to be used and whether or not electronic low-touch or high-touch trading is required, says James. What’s more, a new updated version of MiFID is on the horizon calling for more rigorous pre-trade and post-trade transparency.

While outsourcing trade operations might sound like a panacea to all this complexity, it isn’t for everyone. It is impossible, say both internal and external trade operations specialists, to gauge just how much a fund manager could save through outsourced trading operations as it is directly related to their trading frequency. What is certain it that the outsourced scenario converts the fixed overhead of maintaining trading operations into a variable cost, related to just how much trading is going on.

“Emerging firms with fewer internal resources or managers with longer investment horizons might prefer outsourcing,” explains Jack McDonald, president of San Francisco-headquartered Conifer Securities, which has been providing outsourcing trading services for over 20 years and bought Morgan Stanley’s operation in 2008. The firm, which has over 100 fund manager customers, offers outsourced trade execution mainly to US fund managers dealing in North American equities.

Mature fund managers with deeper pockets might prefer to keep the trading operations in-house. So might the hedge funds that rely on high-frequency trading. After all, they would be well-stacked with quant experts, who consider their trading strategies to be secret sauce that needs to remain in-house, explains McDonald.

Regardless of size, fund managers who do not trade throughout the day might not need the expensive burden of full-time dedicated traders and related systems. A significant number of long/short equity hedge fund managers use fundamental research and build somewhat concentrated positions, so they don’t require a full-time in-house trader, says McDonald.

But that doesn’t mean other asset managers should erase any thoughts of outsourcing their trading desk from their minds. “There are cases of asset managers wanting to quickly expand in a particular asset class or region,” says James. “There is no one size fits all approach, so we are flexible enough to accommodate multiple requirements.”

Five trading desk specialists at US fund management firms who spoke with FinOps Report on condition of anonymity project the greatest traction for outsourced trading operations could come from buy-side firms either wanting to quickly expand into a new asset class — namely fixed-income — or a region. Asia-Pacific was cited as fertile ground as it would be far harder to set up shop on the ground given language barriers, diverse regulations and multiple clearinghouses and depositories. BTIG LLC, for one, has made a name for itself offering outsourced trading operations for US fund managers wanting to expand into Asia-Pacific and most recently for Asia-Pacific fund managers themselves.

Multiple Flavors

Setting their sights on the diverse needs of asset managers, third-party trading operations providers will provide not only a modular offering, but also last-minute help in a pinch. “Outsourcing doesn’t necessarily require the fund manager to relinquish control of its entire trade operations process,” explains McDonald. “In some cases, we have been asked by very large fund managers to step in as a backup plan where a trader is either on holiday or falls ill. The only objective is to make the process seamless for the end fund manager client.”

Deciding whether or not to outsource trading operations is serious business. It can’t be decided overnight or be the responsibility of a single C-level individual at the fund management firm. Although chief executive officers typically make the final call, suggests James, the outsourced provider should ideally have preliminary talks with the chief financial officer, the chief operating officer and the chief investment officer.

Of course, satisfying all of their respective and potentially conflicting needs takes just as much skill as doing the trade operations work. CFOs might be far more interested in hearing about cost reductions, while COOs and CIOs will ask about FIX-trading capabilities, reporting and TCA. “Ideally, all of the stakeholders in the process strategically agree on the benefits of outsourcing,” says James.

Not only will those benefits need to be pretty well-understood, but so too must the method of monitoring the ongoing relationship. Getting hitched is just the beginning of the dance between a fund manager and its outsourced trade support provider.

James says that BNP Paribas Securities Services takes a two-fold approach, the first of which is to hold a formal meeting to ensure all of the stakeholders — the CEO; CIO; CFO; COO and portfolio manager — to review what has been done and provide feedback on agreed-upon key performance indicators or KPIs. Such a process will include TCA reporting.

A secondary and less formal analysis will take place between the portfolio manager for a specific fund and outsourced trading desk specialists to iron out specific issues such as broker pricing; broker electronic offerings, regulatory changes and workflow adjustments.

Not all fund managers want to handle such rigorous relationship management. In a few instances, they may simply choose to trust the third-party trade outsourcing provider and not do any further monitoring. Or they may just be satisfied with getting the TCA reports.

Regardless of just how much of the trading operations desk the fund manager decides to outsource or how much monitoring it wants to undertake, fund management trade operations and external service providers all agree on one thing. As efficient and cost-saving as outsourced trading operations can be, it’s not for everyone. As with any kind of outsourcing, fund managers will have to examine the opportunity carefully before buying in.