Outsourcing is not black and white. There are grey areas that can benefit your business
The key differentiating activity of Asset Managers is their product offering and investment process. Once portfolio managers have decided in which instruments to invest, someone has to go to the market, assess which execution strategy is beneficial and buy that instrument at the best possible conditions. Enter the role of the execution desk.
Considering that running such a desk can cost £1.5m /year for a 3-person team (incl. comp, tech, terminals, data feeds, storage), it would cost the Asset Manager 10bps if he manages £1.5bn in assets. For smaller hedge funds and family offices, 10bps can be prohibitive cost of execution.
And a 3-person desk very rarely has a multi-asset class capability and/or does it cover all time-zones.
Larger Asset Managers might be in the position to afford their own execution desk, but their desk may still not be large enough to compete with the execution capability (in terms of liquidity access, negotiation power, execution quality) of large asset managers (i.e., Blackrock, Fidelity, Amundi) or even outsourced execution providers. It could also be that their execution desk is not providing a clear contribution to performance or the Asset Manager's value proposition.
Should you do it yourself?
So, should you run your own buy-side desk or outsource it?
To answer this concretely, you have to answer the following questions:
Is your execution desk delivering alpha consistently for your products (and is that alpha obvious to the organisation)?
Is your execution desk creating added value that enables a unique product offering/supports your value proposition?
Is your AuM significant enough to justify the cost impact of running your own execution capability?
If the answers aren't obvious to you then you might benefit from outsourcing your execution capability.
In some cases it makes no sense
If you cannot explain, and the organisation and its clients do not understand the current and future overall value of the internal execution capability, why should the company allocate resources to it? It will cost the company a great amount of resources to establish, run, and develop the execution capability to stay at least on par with the market, e.g., people, maintenance of systems, improvements/upgrade of systems, real-time data feeds, office space.
Outsourcing is not black and white. There are grey areas that can benefit your business
How exactly can Asset Managers benefit from delegating flow to 3rd party providers, if at all? These providers typically offer three models:
Prime services: you use the providers as brokers, leverage their market access, their broker network and expertise, asset class and time zone coverage, and they provide you anonymity since they face the street. Settlement is with the outsourced execution provider.
Supplemental trading (some also call this "hybrid insourcing"): you cover what provides added value to you and your clients in terms of asset class and/or regional expertise and supplement it with a 3rd party provider to:
Enhance your asset class, time zone coverage, broker network and liquidity access, and market specific expertise at lower risk (e.g., having one trader to cover one region vs. guaranteed coverage from a 3rd party provider)
Strengthen your business continuity plans
Reduce costs or better manage in areas you don't/can't provide significant added value (e.g., trading low volumes in very liquid instruments)
This can be done in two ways:
The 3rd party team is with the provider in their different locations using their own or the Asset Managers' systems (most providers still show this flexibility)
The 3rd party team is on client premise (less relevant in these COVID times) and interacts directly with the internal trading and portfolio management team using the Asset Managers' systems
3. Fully outsourced trading: The provider typically uses his own technology, people, and processes, and investment managers connect via standard interfaces. This service would also typically include research, market color, execution quality analytics.
Which concerns exist when outsourcing such an intricate part of the business?
Asset Manager: How are conflicts of interest managed?
TGGC: We see that outsourcing providers know this is a sensitive topic and have prepared for it. Their models are agency only, when belonging to a sell-side company they enforce strict Chinese-walls (we nevertheless recommend to perform due-diligence on this point), they offer toxicity analysis to prove low to no levels of information leakage.
Asset Manager: What happens in a big market correction? How will my trades get prioritised?
TGGC: This depends on the model you choose. If you have a dedicated desk assigned to you, then there is no difference to an internal desk (be it supplemental or fully outsourced). If you don't have a dedicated desk assigned to you then it will be first-in, first-out.
Asset Manager: Does the outsourcing provider accept fiduciary responsibility for the clients' best execution?
TGGC: The fiduciary responsibility remains with the Asset Manager. Nevertheless it is key for Asset Managers to have governance processes to help them enforce and hold their outsourcing provider accountable for delivering best execution.
Asset Manager: In which scenarios is there a business case to outsource?
TGGC: Outsourcing providers do benefit from economies of scale (especially when you think of their IT cost, broker network management, overall overhead), so that they can offer their execution service at a competitive rate vs. the Asset Manager's internal desk. If the cost creates a business case for you depends on the model and the required coverage scope and quality compared to your current cost base.
It is important to highlight, that outsourcing providers typically charge x-bps per trade. This allows for the cost to be carried by the funds and not from the Asset Manager's PnL (subject to the regulation of the fund's jurisdiction).
Asset Manager: I need expertise in Emerging and Frontier Markets.
TGGC: Most providers have 24 hour coverage and execute in every Emerging and most Frontier Markets.
Asset Manager: Investors and Asset Managers need a comprehensive evaluation of best execution.
TGGC: The Best-Ex and TCA discussions are typically quite in depth. Trading is evaluated by strategy and by reason codes. Among other things, you'll see how your portfolio managers are doing in terms of arrival price.
Asset Manager: Do Asset Managers lose market insights?
TGGC: It appears that because outsourced trading desks are larger, see more volume, and have a wider broker network, they get more market colour. If this is key to your investment process, we would suggest you talk to the providers with larger flow.
Factors to compare outsourcing providers and choose the best fit?
Risk and quality of execution
Depth of integration with portfolio managers
Depth of integration with you mid office
We recommend to start with the providers' high-level offering to accelerate the screening process.
Main players in the market (list not comprehensive):
The solutions offered can provide small and medium size (USD <1tn AuM ) Asset Managers the execution capabilities' benefits only the largest ones have. Either by fully outsourcing, supplementing, or by using prime services. If the execution capability is not creating a differentiating factor, outsourcing, in its different forms, can help Asset Managers focus their resources on what moves the needle for them and their clients.
Potential benefits can be listed as such:
Leverage the economies of scale to access liquidity on the street
Anonymity to the street
Higher, inherited market power
Cost flexibility / ability to charge the fund
Time-to-market when expanding regional, timezone, asset class coverage
Overflow service when the internal desk has too many orders to manage (though, the outsourcing provider might not be familiar with the AM's flow and trade intentions)
Reduction of regulatory burden and adaptation cost
Potential caveats of outsourcing execution:
Losing market insights depending on the chosen model. Especially in emerging markets
Little evidence on how the relationship would develop in times of market stress
The responsibility for Best Execution is still with the Asset Manager (and not a reason for outsourcing)
If the business grows and the execution capability is to be in-sourced, the Asset Manager might not get the historical data with the required level of granularity (e.g., fills)
Unclear effectivity of IPO/New Issue liquidity access
Conclusion - to outsource or not to outsource?
If the positive contribution of the Asset Manager's execution capability is not immediately clear, it may be worthwhile to consider testing an outsourcing provider (prime services onboarding timeline is comparable to that of onboarding a regular broker) to complement the in-house execution desk
So far, most Asset Managers are opting for supplemental trading and not for full outsourcing
If your in-house desk is a strategic capability for your current and future business because it allows a unique product offering or it delivers a superior performance enhancement, then outsourcing your execution would be a business continuity solution at best
The TGGC outlook
We believe that these outsourced execution providers will consolidate in the coming years, thus resulting in large, very professional execution agents, who will make it more and more difficult to justify running your own execution desk. They will cover processes linked to execution (i.e., trade processing, securities operations, collateral management, repo, trade surveillance, regulatory reporting) and will be able to provide deep data analytics and very high levels of automation. What will happen to the market, and especially to the sell-side with such buy-side execution giants? We can only say that we're excited to be a part of this journey.