Outsourced Trading, Part 1: Buy-Side Perspective

The buy side is going through a transformation that we have not seen in decades — driven by intensifying margin compression. Fee pressure emanates from the growth in market share of low-cost passive funds and exchange-traded funds (ETF), while costs are on the rise due to expanding regulatory requirements and responsibilities placed on the trading and compliance functions.

Many investment management firms are dealing with margin pressures by cutting headcount from the operations and trading units. During this restructuring process many firms are looking at outsourcing operational aspects of the business as well as outsourcing all, or parts, of the trading desk functions.

Although, historically, the demand for trading desk outsourcing came from start-up hedge funds and smaller managers, that could not afford their own in-house trading team, the recent buy-side restructuring push is creating new demand from larger firms investigating outsourced trading cost management strategies. However, as the diversity of outsourced trading firm types and service options increase, managers searching for outsourced trading partners are often left with more questions than answers.

Much of this demand from larger managers is being driven by the outsourced trading service model’s utility in taking the fixed cost of maintaining an in-house trading desk, paid at the manager level, and converting this to variable commissions paid at the fund level.

Besides converting trading costs from fixed to variable, outsourced desks provide the buy-side with access to their wide network of sell-side relationships, which can reach up to 200–300 sell-side brokers. 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 given name.

Smaller managers are more likely to outsource all of their trading, while large managers typically outsource only a part of the trading responsibility, such as the night desk or emerging markets coverage.

However, outsourcing is not a panacea and there are many challenging concerns. The biggest concern is the governance structure of the relationship to ensure that the outsource partner is fully aligned with the fund, which can fulfill the funds’ fiduciary responsibility to its clients, keep proprietary information confidential, and adequately manage the risk intrinsic to the widening communications gap between an increasingly distant trading desk and the in-house portfolio managers.

To help managers look at this space, TABB Group conducted in-depth interviews with 30 buy-side traders and 30 outsourced trading desks to provide answers to the questions facing the buy side the most.