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U.S. equities buy-side trading firms are going through a transformation not seen in decades, driven today by intensifying margin pressure, with many looking to outsource all or part of their trading functions to cut costs.
Based on a 40-plus page, two-part TABB Group research report written by TABB senior analyst Michael Mollemans, “Outsourced Trading, Part 1: Buy-Side Perspective” and “Part 2: Outsourced Traders’ Perspective,” firms across the brokerage industry say they are adapting to clients’ changing service requirements by entering the outsourced trading service space.
Historically, outsourced trading started over 20 years ago as an option for start-up hedge funds that couldn’t afford an in-house trading team. Fast forward to 2018–2019 and there’s an unprecedented sudden growth in demand for outsourced trading services with a remarkable number of firms entering the outsourced trading service space. “What’s different now is that demand for outsourced trading is not only coming from hedge funds,” Mollemans says, “but from medium- and large-size investment managers, as cost pressures on active managers continue to intensify, as low-fee passive funds and exchange-traded funds (ETFs) gain market share.”
“Outsourced trading introduces economies of scale and efficiency gains into the buy-side trading process at a time when MiFID II and the unbundling of research put the cost of trading into the limelight, this while competition from passive funds has intensified fee compression,” says Mollemans
The reasons are clear. Larger asset managers are eager to outsource parts of their trading process, just as larger brokerage firms are entering the outsourced trading service space. Differentiation of service offerings provide choice to clients by capitalizing on strengths in technology, network of sell-side relationships, access to block liquidity, transaction cost analytics and prime brokerage services. At the same time that buy-side firms are reducing their broker panels to tighten flows, communication and improve efficiencies, outsourced trading firms offer access to a wide network of 30-300 sell-side broker relationships that can be useful for one-off research reports, local market color or to help facilitate natural block cross opportunities. Size matters, as 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.
Despite this rapid transformation, there is no one-model of outsourced trading as traditional sell- side brokers, prime brokers, clearing and custody banks and technology firms are entering the space with their own unique brand of outsourced trading service offerings.
Outsourcing, however, is not a panacea and there are many challenging concerns, according to Mollemans, as governance will be an increasingly important aspect of the outsourced trading relationship. “The stakes go up when larger firms outsource parts of their trading process. If the quality of information flowing back to the portfolio manager suffers, then the performance of the fund will suffer. Poor performance in the outsourced trading service model goes beyond price versus VWAP or arrival benchmarks – it goes all the way up the alpha chain to the portfolio managers’ core strategies.”
This two-part report is based on interviews with a cross-section of 33 outsourced traders located across the United States – New York, Boston, Connecticut, Washington, Seattle, San Francisco, Chicago, Dallas and Utah – and Europe – London, Paris and Geneva. Mollemans also interviewed 30 buy-side firms to gain perspectives on what outsourced trading features they appreciate and what concerns them.
Both reports, “Buy-Side Perspective” and “Outsourced Traders’ Perspective” are available for immediate download by TABB equity clients and pre-qualified media at https://research.tabbgroup.com/search/grid.
For more information or to purchase both reports, write to info@tabbgroup.com.
