In an increasingly complex and competitive asset-management business, delegating trading to an execution specialist has gained appeal.
The premise is that buy-side firms of all stripes — from small registered investment advisors (RIAs), to medium hedge funds, to larger long-only managers — need to stay on top of product, strategy, and distribution. They may not have the expertise or the scale to optimize trading, which results in suboptimal trading that dissipates alpha and can be a drag on the whole business.
“The industry is looking toward efficiencies and expertise,” said David Beth, president and COO of WallachBeth Capital, a provider of institutional execution services. “As the investment management space grows more sophisticated, personnel needs are shifting to organizing outside specialty service providers rather than implementing solutions in-house.”
Outsourced trading has always existed to some extent, but it has come more to the forefront in recent years as an asset manager’s organizational needs become more sophisticated and complex, and running everything in-house can put mid-tier and smaller firms at a disadvantage. Outsourcing high-bandwidth functions like trading becomes a real option to stay nimble and maintain a competitive advantage. Because the resources and expertise required to fully implement an internal trading operation are significant, partnering for some or all of the trading function becomes an easy place to start the conversation.
The adoption of outsourced trading has ramped up over the past year, when heavy volumes and volatility roiled markets and working from home amid COVID-19 challenged buy-side firms’ operations.
According to a Greenwich Associates poll conducted in the third quarter of 2020, 32% of buy-side equity traders said outsourced trading desks are a good solution to help them manage their order flow while achieving best execution. While 27% of respondents said outsourced trading desks were just like other brokers, that number was down from the almost 50% who held that same view in 2019.
“Why do we see such a shift? For good reason,” stated the report, written by Shane Swanson, market structure & technology analyst at Greenwich. “As the world becomes more complex, buy-side firms need to decide where they want to focus in order to make their mark. For some firms, that will mean a relentless passion for client service. For others, it will be a never-ending quest for alpha signal or a deep dive into the market micro-structure dynamics on which the slightest shift may change losers into winners and vice-versa. What becomes more and more clear, however, is that many firms do not have the resources to cover every aspect of every market, from execution to clearing to settlement to regulation and beyond.”
Outsourced trading enables a buy-side firm to focus its expertise on what it’s best at, and achieve a scale that it otherwise couldn’t have, according to Jennica Ross, managing director and head of strategic relationships at WallachBeth. Outsourced trading is often perceived as an all-or-nothing business decision. Because trading encompasses such a broad range of important activities and skill sets, it is often easier to outsource a segment of the operation to a partner.
For example, it might make sense for a manager to keep equity trades in-house, but outsource the more complex and esoteric fixed income, derivatives, and/or ETF trading to a specialist.
“Outsourced trading can be as much or as little as you want it to be,” Ross said. “It isn’t necessarily about the size of the asset manager, rather it’s the scope of what they’re trying to do and what they are trading. A smaller asset manager might need a full-scale outsourcing, while a large, established manager that’s broadening its investment strategies and product offerings might need to outsource a facet of its trading. There is no one-size fits all.”
In 2020, churning markets and a severe downturn early in the year was followed quickly by a sustained rebound; 2021 so far has seen continued volatility, with mixed signals on market direction. Fast-moving markets and uneven liquidity typically mean wider bid-ask spreads, making trading acumen especially valuable.
“In times of high volatility like what we saw last year, being able to leverage experience and a deep knowledge base became even more critical to delivering client outcomes,” said Erik Ambrose, managing director at WallachBeth. “An outsourced trade desk is an important extension of the asset manager itself – it can make the link between a portfolio manager and the market much more robust without a heavy resource commitment.”
