Outsourcing Trading

Being an asset manager in today’s market can be a bruising experience. Margins are shrinking and fees are under pressure, while operating costs have grown out of proportion. This is happening in tandem with unpredictable markets, making alpha creation for clients exceptionally difficult. Cost-saving opportunities have to be identified wherever possible in a way that does not compromise the integrity and success of the business. Linear Outsourced Trading has sponsored this paper to look at some of the trends which are pushing asset managers towards outsourcing their trading desks to third parties.

The cost burden
It is no secret that active asset management returns have not been in line with investor expectations. In a forceful indictment, the UK Financial Conduct Authority (FCA)’s Asset Management Market Study Interim Report stated that active asset managers routinely underperformed their benchmarks after fees. It also questioned why the industry’s fees had not fallen as competition proliferated, something which has occurred in the passive fund sector, where there has been a race to the bottom on investor charges. All of this has contributed to the enormous growth in lower-margin passive products, which, despite a fivefold increase in the UK since 2005, are still expected to gain market share.

The FCA’s comments will naturally embolden investors to apply leverage on their active management fees. Such pressure will cause some firms to rethink their internal operational structures, and look for cost savings. The gravity of the situation facing asset managers is severe. According to a Financial News poll of leading asset management firms, 74% of Chief Investment Officers (CIOs) expected fees to fall in 2017. None expected fees to rise. In another study, Casey Quirk (part of Deloitte) forecasts that asset managers’ median profit margins will fall nearly 18%, from 34% to 28% by 2021.

The industry should be worried, as its very foundation is seemingly under threat from spiralling costs. So what major cost overheads can be scaled down? Traders do not come cheaply. The fully loaded cost of a typical trader with experience has been independently estimated at £300,000, meaning that even the cost of a small team could be close to £1 million. This is an overhead many managers could do without. Outsourcing a trading desk to a trusted third party could save hundreds of thousands of pounds, allowing firms to invest elsewhere in their business.

The race to comply with regulation
Regulation is a significant cost for fund managers. Following the financial crisis, regulation has eaten into fund managers’ margins, forcing them to make additional hires, particularly around legal and compliance, and upgrade their technology and systems. The Markets in Financial Instruments Directive II (MiFID II) will be law in less than twelve months, and it is a deadline that fund managers need to be working towards urgently. Non-compliance is not an option.

MiFID II covers a number of issue areas, but none are more important than unbundling. Research from sell-side brokers is typically paid for in equity commissions from managers, but this EU regulation will mean that payment for research and execution services must be separate.
 
A study by research firm RSRCHXchange, of more than 200 predominantly European asset managers, found that one-third of respondents had little idea of when they would be compliant with the rules, although half anticipated to be ready around summer.

Fifty per cent of the firms in the survey were still uncertain about how to pay for research. The current environment and outlook means most buy-side firms are reluctant to incur the costs of research themselves, but some are taking the moral high ground. RSRCHX said 19% of asset managers intended on paying for research from their own P&L, putting further pressure on margins, while 9% suggested they were in favour of passing on the cost to their clients – not an easy task when there is so much pressure on fees.

The consumption of research has been falling as firms have been forced to set monetary budgets, and this reduction looks set to continue. RSRCHX analysis said 54% of the biggest firms expected their research spend to drop once the rules kick in. This is supported by a Financial News poll which found that 36% of CIOs from 23 firms managing more than £7 trillion will cut back on bank research. However, asset management firms are highly reliant on external research and there is likely to be a point where investment performance may suffer if the research spend is cut too severely. If asset managers decide to pay for research themselves – either externally or internally produced – they may have to assess whether having sufficient research or an in-house trading capability is more valuable.

Demonstrating to regulators that research and execution are divorced from each other is now a priority for asset managers, particularly where individuals perform both functions. The reporting this will entail is also a huge cost for smaller managers. Some buy-side firms increasingly recognise that physically extricating trading desks and outsourcing such activities to a credible third party is a logical approach to take if they want to highlight to regulators that execution and research are unbundled.

Why are asset managers beginning to consider outsourcing trading?
In the past, portfolio managers have been reluctant to embrace outsourced trading primarily because sell-side research was interlinked with trade execution. Other concerns included potential information leakage and loss of control. So what has changed?

Beginning January 2018, research payments must be separate from trade execution commissions. Portfolio managers’ historical concerns that removing the trade execution from the research provider would affect the quality or quantity of research are becoming irrelevant. Client confidentiality and market abuse monitoring are regulatory obligations and any risk of information leakage is further reduced if there is no incentive to pass on information.

Trading desks are increasingly seen as a cost at a time when overheads are being closely scrutinised. Cost pressure on the sell-side initially encouraged the growth in electronic trading, and the same pressures, together with changes in market structure, have encouraged the buy-side to follow a similar path.

As a result, trading has become highly commoditised and many trading desks are not adding the value they did previously. It is understandable that managers like to be collocated with trading but it is a luxury that they can ill afford, and one that can be replicated within a far more efficient structure.

Outsourced trading is likely to become common practice. Compliance was once seen as a function that had to be internalised by managers, but attitudes have changed. A similar mindset towards dealing desks among investors and CFOs/COOs is clearly visible. Economic reality, and not sentimentality about old trading methods, is likely to drive strategy.