Who is using outsourced trading?

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A new study by analyst firm Capco has outlined the drivers, pros and cons for buy-side outsourced trading, yet Capco was unable to say how much outsourced trading is happening today.

There has been much publicity around the drivers for outsourced trading, but where data is available, uptake appears to be happening in a specific and limited way.

Northern Trust currently reports having 61 clients using its outsourced trading services, up from 23 in 2018, all of which it notes are institutional and involved in a range of public equities, fixed income and derivatives investment strategies. These are typically in the US$1 billion to US$10 billion assets under management (AUM) range of traditional long-only asset managers.

In a survey of 300 fund managers, mostly private equity specialists with less than US$50 billion AUM, which was published by WBR Insights and Northern Trust in June 2020, 17% of firms reported they outsourced trading functions, equating to about 51 firms.

A 2018 report into outsourced trading by Greenwich Associates, which surveyed 44 asset managers of whom 9 had an AUM over US$10 billion, 48% of respondents were currently working with at least one outsourced trading desk.

Capco noted in its new report that outsourcing was particularly of interest to hedge funds, but also cited a study from consultancy Opimas in 2018 which had predicted that by 2022 about 20% of investment managers with assets under management greater than US$50 billion will outsource some portion of their trading desks.

A large number of firms offer outsourced trading – Capco cites 17 providers – suggesting the estimated market size by outsourcing providers is significant. Northern Trust also says the size of the firms it is engaged with is changing. “As we grow, not only do the size and sophistication of manager grow, but so too the complexity of their instrument coverage,” noted a spokesperson.

If focused on the sub-€10 billion (US$11.7 billion) AUM market, that would still present a target of 113 asset managers globally out of the top 500 firms.

Hard to fill
Putting analyst predictions aside, it is hard to find real-money firms that have outsourced trading today. Pension fund Railpen had engaged in a well-reported deal in 2015, but its annual reports for all subsequent years reference its growing “inhouse trading capabilities”; the current state of that outsourcing project is unknown and it did not respond to requests for comment. Hedge fund manager Ardevora, (US$5.1 billion AUM) was contacted for this article and outsourced its trading operations in April 2020. One fund manager contacted had supplementary outsourced trading capacity if needed, but still operated a centralised trading desk.

Primary drivers to outsource trading as laid out in the Capco report include:
• Cost saving, with higher trading costs and lower revenues the costs of both technology and staff can be reduced via mutualisation through an outsourced provider, along with movement to a variable or on-demand cost model;
• Passing on regularity requirements such as MiFID II obligations;
• And access to wider trade support such as 24-hour markets, larger broker network and larger liquidity pools through higher trading volumes provided by an outsourced provider.

Amongst the buy-side firms spoken to for this article, the value of outsourced trading was most clearly seen in adding value to services – allowing discrete trading of large positions in small cap names for example, or accessing a more expansive broker list in less traded markets which cannot justify permanently onboarding of brokers.

Cost rarely surfaced as a driver, primarily because making trading decisions based upon the lowest explicit costs risked ignoring higher implicit costs, such as market impact and implementation shortfall which can be more significant.

There were also concerns about the way costs of trading could be allocated via a third party. Under MiFID II an asset manager must pay its trading costs, and make them transparent to the client. However, if a fund is paying a fee to a service provider without the intermediation of a trading function, it is possible that trading costs could be hidden from the client.

The trading process is integral to the investment process, and provides valuable input into wider portfolio and risk views, which makes any outsourcing of the function – even partial – contingent upon considerable value being generated as a result. Information captured by the trading team was seen as feedback that would be wasted if it were shared across multiple other rival firms.

Clearest view
A lack of conflict between business areas, access to natural liquidity and being seen as a genuinely ‘buy-side’ trading desk were all seen as positive attributes for a firm offering outsourced trading.

Several buy-side interviewees felt approaches that outsourcing providers had taken in sales approaches and marketing strategies were misrepresenting the business capabilities offered and the firms’ client bases.

Across a wide range of real-money asset managers, spoken to for this article, all with AUMs of over US$10 million, all had centralised trading functions, and only one had supplementary cover from an outsourcing provider.

Getting to the facts, based on supplied by the providers themselves and all of the available research published in the public domain, it seems clear that asset managers with up to US$10 billion AUM, can potentially find value in outsourcing trading. However, there is no clear evidence that the model has found fertile ground with any larger asset managers to date.

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