This article was written by Martin Coughlan, CFA, CAIA. Martin has spent over twenty years working at asset management firms globally.
In part 2 of our series, we discussed the reasons why investment managers may wish to consider outsourced trading. In this paper, we will look at the common objections we hear from investment firms and the areas they should focus their due diligence on as they assess outsourced trading providers.
Business structure conflicts of interest and execution capabilities
We believe that it is imperative that investment managers investigate potential conflicts of interest fully. While there are a significant number of firms offering outsourced trading capabilities today, we believe managers should focus their due diligence on agency only firms that do not engage in proprietary trading or investment banking activities.
It is critical that your outsourced partner is unconflicted in terms of flow. Attention should be paid to ensuring that there are no internally developed algorithms, ownership of any trading pools, or pledges to any pools that could introduce potential conflicts of interest.
Strong consideration also needs to be given to the breath of trading venues utilized across algo suites, ECNs, ATS’, dark pools, and market makers
First and foremost, investment firms are paid to act in a client’s best interest and maximize investment returns. Ensuring best execution in trading is a fundamental part of this.
We do not believe that best execution should be a concern given the size, scale and expertise of many outsourced providers, the breath and quality of their execution capabilities and ability to effectively report on best execution. In fact, we believe that the underlying clients of investment firms will benefit from improved execution.
As part of any move to an outsourced trading model, it is key to determine how best execution will be measured independently through third party Transaction Cost Analysis.
Confidentiality and Anonymity
Implementation of an investment manager’s strategy in a confidential and discreet trading manner is generally very important. This is built into the outsourced trading relationship as the outsourced provider is trading in its own name with no disclosure of the underlying manager’s (or client’s) name/s.
Historically, portfolio managers have viewed the proximity of their trading team to be important. Working from home during the pandemic has changed the view of many as they have found they can work remotely while maintaining strong levels of communication.
Deciding to move to an outsourced model, particularly a fully outsourced model, will likely lead to personnel departures. We do believe that retaining one member of the trading team to manage the outsourced relationship may make sense for some firms if the person’s time can be maximized with other responsibilities. We have seen examples where the person who is retained can take on further vendor analysis/management responsibilities in areas that effect the investment team. We believe over time that this will become more important as firms increasingly look at ways that investment management focused fintechs can help their businesses.
Should a firm decide to outsource trading, we believe it is important that the portfolio managers are comfortable with the change and that they build strong relationships with their assigned trader/s at the outsourced firm. We believe it is best practice for the portfolio managers to be involved in the selection process of an assigned trader at the outsourced firm.
Another potential model is where an existing trader at the investment manager moves to the outsourced firm and becomes the assigned trader for their old firm. The potential for this will obviously be dependent on the economics of the trading business the outsourced firm is taking on.
Investment managers worry about communicating any type of change to clients and consultants. Our experience over the past number of years is that outsourced trading has become mainstream, and clients and consultants are comfortable with the move if investment managers can demonstrate the due diligence they did in selecting an outsourced firm, how they will manage the outsourced relationship and evidence of best execution not being impacted.
While many investment firms will get comfortable with outsourcing trading of institutional separate account and commingled funds, they believe that the effective outsourcing of SMA/Wrap accounts is not possible.
This is a topic that deserves detailed analysis, and we will discuss it in more detail in the fourth and final part of our series.
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© 2022 Acclinate LLC. Paper commissioned by CAPIS
Acclinate’s founder is Martin Coughlan, CFA, CAIA. He spent over twenty years working at asset management firms globally. He has experience across the investment, distribution and operations functions. As a member of executive committees at three different asset managers, he is very much attuned to the challenges and opportunities that the buy-side faces. He has been involved in a number of outsourced trading implementations at investment firms that previously employed legacy trading desks.
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