By Paul Kelly
Traditionally, hedge funds and other investment firms have maintained in-house trading staff to operate in financial markets. However, a growing trend is to outsource this so that asset managers can focus on managing their portfolio, and the nuance of trade execution can be done by another firm. According to a survey by Northern Trust, 17% of surveyed asset managers already use outsourced trading, with 82% of the remainder expressing interest in outsourcing trading.
A key driver of outsourcing trading is scalability. As the business expands and contracts, costs can be scaled to match, whereas if trading is kept in-house, costs are fixed. Moreover, when asset managers deal in global equities, commodities or even cryptocurrency, there is a need to maintain a 24-hour trading operation with a wide skillset, often across different countries. This entails high costs. Instead, it can be cheaper to outsource to firms that can execute these trades at a large scale.
Keeping costs down is also important due to increasing interest in ETFs, which have increased in value almost fiftyfold from $204 billion held in ETFs in 2003 to $10 trillion in 2021. Since these funds are relatively low cost, with an average expense ratio of 0.45% in the US in 2019, asset managers are under pressure to either reduce costs or increase alpha in a cost-effective way. Therefore, outsourcing trading may be an effective way of staying competitive.
Before the pandemic, it was seen as necessary for portfolio managers to be in the same room as traders for quick communication in a fast-paced environment. However, the move to remote working in the earlier stage of the pandemic has shown that people can work effectively remotely and removed the psychological barrier that everyone needs to be in the same room.
Additionally, outsourcing can help asset managers keep pace with a climate of often intensifying regulation. The fact that Russian oligarchs, for example, are able to circumvent sanctions by using cryptocurrency, has prompted Western regulatory authorities to consider regulating cryptocurrencies. Outsourcing can allow firms to offload the burden of compliance to specialists rather than having to maintain in-house staff.
In the same vein, asset managers often need to maintain staff with very specialised skill sets. This can present a risk of skill retention. If one key trader is lost, it can take a significant amount of research to find talent and then train a person in the procedures of the company. This problem is mitigated if the trading operations are outsourced.
There are also technological benefits to be reaped form outsourcing trading. For example, updating legacy systems or introducing new technologies such as machine learning into investment algorithms requires a significant amount of time that distracts from the core business and interrupts the business flow. With outsourcing, asset managers can choose a firm that caters to the technological needs of the portfolio without having to be concerned with business disruption.
Although there is a certain anxiety in giving up control of a front-office activity through outsourcing, it is clear that outsourcing is competitive and, when the trader and the manager of the fund are different people, it doesn’t make sense to expect traders to generate alpha, in-house or otherwise. Taken as a whole, outsourcing trading allows asset managers to focus fully on their core competencies and reduce cost.