An increasing number of buy-side businesses have considered outsourced trading lately. In fact, a 2020 survey of 300 global asset managers by Northern Trust found that 85% of respondents either already outsource their trading desk or are thinking about doing so.1
This statistic is borne out by our experiences. At Northern Trust, we’ve brought more than 70 asset managers onto our outsourced trading platform in the last four years. During this considerable growth period, one of the first questions possible asset managers ask is: “What is going to my clients think?” The question stems from the belief that an asset manager with out a trading desk is like a ship with no captain. The worry from the key decision makers at the asset manager, especially the client-facing ones, is the fact your choice to outsource trading will cause a flight of assets.
However, after a long time of working with some of the greatest and most dynamic asset managers, I’ve found the other to be true: assets are not flying out the door when trading is outsourced. Plan sponsors and asset allocators recognize that outsourced trading contributes to efficiency gains and increased expertise, which includes actually been a tailwind for asset managers who’ve outsourced.
The change was gradual. In 1999, Vanguard-a champion of low cost, passive strategies-only had $500 billion in assets, in comparison to $8 trillion today2, so that it is the second major asset manager these days. Index funds also represent the major investment class at Blackrock, the world’s major asset manager.
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During this rise of indexed investment strategies, many of the factors that drove the rise of the buy-side trading desk also have shifted. Markets are more efficient today. And while there is still work to be done to drive down frictional trading costs, regulation (such as Reg NMS in the US and MiFID II in the EU), decimalization, increased TRACE reporting for bonds, commission compression and much more transparency in the markets (to mention but a few changes within the last 20+ years) have resulted in substantially better markets. Fees paid for active management have been under pressure (and will likely remain so). Several new investment avenues have emerged offering compelling alternatives to traditional public market investments. And the cost to operate a trading desk has steadily risen. For example, as advanced technology becomes available in the marketplace, it is an increasingly complex and expensive project to upgrade outdated systems to be able to take good thing about the hottest tools.
Today, operating a trading desk has turned into a non-essential component of a successful asset manager’s front office. And buy-side firms are continuing to find greater advantages to outsourcing some or all their trading function.
As asset managers attended full circle on their trading desks, plan sponsors and asset allocators stand to get from outsourced trading trends. They recognize the pros and have embraced the final results, which include:
Healthier asset managers: The price to assist a trading desk is significant. For instance, the desk must be staffed for peak volumes and anticipation of staff absences. On an average day, there exists spare capacity, rendering a trading desk an inefficient use of capital. And infrastructure costs continue steadily to increase to keep up with regulation and rapidly changing markets. Outsourcing eliminates the pressure to keep a trading operation.
Healthier returns: When an asset allocator hires a secured asset manager, they need to know that their manager is focused on what they do best (portfolio oversight and making strong risk-adjusted returns). By outsourcing the trading function, buy-side businesses have had the opportunity to raised give attention to their core business of portfolio construction. Rather than buying trading, asset managers are increasingly buying tools and technology to augment alpha generation. For plan sponsors and investors, this shift is effective.
In-house managers: For assets that a plan sponsor manages in-house, outsourced trading provides expertise needed to express view in the market. As trading is a scale business, outsourced trading vendors with larger trading operations and even more flow simply have an edge in the market. More trading flow allows for more usage of liquidity, better pricing, and increased access to primary market offerings. In addition, a larger trading operation results in better expertise and increased specialization. An outsourced trading desk will have, for example, traders that focus on certain types of trading, such as programs or blocks, as well as individuals that have unique experience in a particular security, such as asset-backed bonds or small cap stocks.
Start up and specialist asset managers: The price to regulate a trading desk is proportionally higher for asset managers focused on a particular segment or niche. Outsourcing the trading function puts start up and specialist managers on the more even keel with the industry’s largest managers.
Institutional investors, plans sponsors, and investment consultants should be ready for the trend to outsource trading among the investment managers and hedge funds that they hire. Because of the many benefits to both managers and end investors, this trend will continue and even accelerate as it becomes more mainstream. There will be situations where asset managers plan to keep an inhouse trading desk, but our expectation is that more of the dealing and trading related functions will be outsourced. So that as plan sponsors and asset allocators grow savvier, asset managers will need to focus on the way they are building portfolios and reaching superior risk-adjusted results. Outsourcing their trading procedures can help them achieve those goals.
