Outsourced trading desks: A new frontier for fund managers
A growing number of fund managers are recognising the benefits of outsourcing their trading desks to third party providers as regulatory and operational costs increasingly mount. The cost of running a hedge fund is growing. A survey by Citi found that a typical hedge fund required $310 million in Assets under Management (AuM) to enable their 2 per-cent management fee to cover all of their operating and regulatory costs. This is a far cry from bygone eras. As such, cost efficiencies have to be realised where possible. An outsourced trading desk can be an effective mechanism by which to achieve that.
Appointing a dealer at a buy-side firm is not an inexpensive undertaking. Most institutional investors want their buy-side firms to employ a handful of dealers to mitigate any issues that may arise through key man risk, and ensure all relevant asset classes are suitably covered. An experienced dealer can cost approximately £150,000, a sum that is considerable for a small or emerging fund manager. As such, the total spend can be as high as £750,000 to £1 million if bonuses and other costs are factored in.
These overheads do not even cover the costs associated with installing and maintaining Bloomberg and other market data feeds, order management and trade execution systems, or any post-trade obligations. It also does not take into account for the regulatory obligation to meticulously document all of these transactions. By outsourcing trading to an external provider, these costs can diminish, enabling managers to refocus on developing other aspects of their business. Given the ever growing cost base, outsourced trading is an avenue managers should be exploring.
Goodacre UK, a consultancy appointed by Linear Investments to produce a white paper on outsourcing, revealed in its paper that more than 50 per-cent of senior regulated individuals said they were evaluating the merits of outsourcing. As such, outsourced trading desks are something that is rapidly gaining traction. Linear’s outsourced trading team currently manages execution for a number of independent funds representing significant AuM and this is set to rise dramatically as other funds finalise their plans. The outsourced trading model has significant traction in the US, and it is quickly catching on in Europe. Managers are overcoming unfounded concerns about losing control of their front office and fears that their brokers will give them a reduced service if they are outsourcing their trading desk.
An outsourced trading desk does not just bring about cost benefits, but improves the quality of execution which is absolutely critical. Utilising an outsourced trading desk can enable a manager to execute their trades on better terms than they might normally have if they conducted this function in-house. Furthermore, outsourced trading desks will cover all geographies and asset classes, and use best in breed technologies. Outsourced trading desks will also have no proprietary positions – again something that should provide peace of mind to fund managers.
There is also a growing regulatory obligation for fund managers to attain best execution. The Markets in Financial Instruments Directive II (MiFID II) is a mammoth piece of regulation. Among its many requirements, it demands firms ensure they obtain best execution for their end investors, and this obliges fund managers to take into account price, costs and speed when executing an order. An outsourced trading desk, with all of its expertise, is well-placed to help managers attain compliance with MiFID II best execution requirements.
But it is not just the MiFID II best execution rules that are going to elevate the importance of outsourced trading desks. MiFID II prohibits fund managers from using equity commissions to pay for brokerage research as regulators seek to unbundle the costs of execution and research. The UK’s Financial Conduct Authority (FCA) also requires managers to pay for research, although it makes allowances when the research has had a substantive impact on investment decisions. In short, the cost of research will now have a material impact on fund managers’ profit & loss should they choose to absorb it themselves, or it will have to be incorporated into the management fee. One solution for managers could be to create research payment accounts, which are pre-funded by investors. This could be an operational headache for some managers. Irrespective, costs are going to increase for managers and having an outsourced trading desk could be a way by which they minimise overheads. Forward thinking service providers such as Linear are exploring ways to assist clients with MiFID II. One route we are looking at is sourcing research on behalf of our clients and charging them a commission on trades executed on the basis of that research.
Running and establishing a hedge fund in today’s environment is challenging. Institutional investors expect institutional standard infrastructure, which does not come cheap. In addition, regulations such as the Alternative Investment Fund Managers Directive (AIFMD), Dodd-Frank and the European Market Infrastructure Regulation (EMIR) to name but a few are all ramping up costs at a time when returns are hard to come by. As such, fund managers need to find cost savings in a way that does not compromise their institutional infrastructure. An outsourced trading desk is one mechanism by which this can be achieved.
For more information, please contact Richard Lilley.