There's More To Outsourced Trading Than Cost Savings
The outsourced trading industry is expected to continue to grow in the coming years. Benjamin Arnold, Founder & CEO of Meraki Global Advisors, explains to AlphaWeek's Greg Winterton the questions hedge fund managers should be asking - and what to look out for - when selecting an outsourced trading provider.
GW: Ben, the outsourced trading industry continues to grow but there are more considerations for hedge fund managers than just cost savings; one of these is alpha trading vs execution trading. What’s the difference and why is it important for hedge fund managers to consider this?
BA: While outsourced trading desks are a great way to reduce fixed costs, it is important for hedge fund managers to consider the trading acumen of the provider; the main reason being the best of breed can also add alpha. They do that by employing higher quality traders and fully integrating into their client’s unique investment process.
To start, let’s talk about the execution trading model. Most outsourced trading desks have adopted the execution model, which is comparable to being covered by your favourite sell-side sales-trader. The fund may be assigned a dedicated trader with a backup, but in all likelihood, the fund will be covered by an entire desk, meaning the entire team, (i) can see exactly what the fund is doing, thereby increasing the potential for information leakage, and (ii) will execute their orders, usually in a single asset class. If a dedicated trader is assigned, its usually not the “A” player, but whoever has the most capacity at that point in time. Success is often based on beating benchmarks, typically arrival price or VWAP [volume weighted average price]. Furthermore, these outsourced traders may very well be sitting on the same floor as the sell-side sales-traders. In such cases, often the fund’s flow is internalised or routed to the venue that most benefits the outsourced firm.
Contrast that with what we refer to as the alpha model. With an alpha model, there will be a discovery exercise involving the outsourced trading provider and the fund’s PM in order to ascertain what skills and personality the dedicated trader(s) from our firm must posses to deliver the best results for the fund. The trader(s) selected must be approved by the PM, and will not only have the expertise, and ability to trade across asset classes, but they will be specialised in the PMs main areas of focus. This allows the PM to seamlessly move through the capital structure if they’d like, to get colour from related markets, and/or hedge FX and other risks. The PM also can vet the trader(s) he or she will be building a long-term relationship with, the same as they would if they hired an internal trader. The traders typically have spent time on both the buy and sell-side and know how to leverage technology and strong broker relationships to achieve best execution. Understanding what the PM values and also mitigating operational risk, coupled with knowledge of the internal workings of a global investment bank provides the fund with best execution, additional value add services and lastly, peace of mind.
Most importantly, an alpha model desk can be fully integrated into the investment process. The trader will know the story around each of the PM’s positions. They can interpret breaking news and relay salient points to the fund’s investment team. They’ll know what types of situations the PM likes and can monitor the market for opportunities. He or she will have intimate knowledge of the portfolio so they can take orders in number of shares, percent of AUM, or target position size. With this model, a constant value-add dialogue can develop between the trader and the PM. Now, obviously when you have this type of integration the trader can’t be sitting under the umbrella of a sell-side firm. The model works best when the outsourced trading firm is structured in such a way that all conflicts of interest are removed, and trust is nurtured between both parties.
GW: Cost savings is important, of course. What kind of savings can a hedge fund manager expect from outsourcing their trading desk?
BA: Heaps! A truly capable and senior in-house trader, along with the proper trading infrastructure, will cost well north of $1mn USD. But, the real advantage of outsourced trading isn’t that it is less expensive, it’s giving asset managers the ability to turn a fixed cost into a variable one that can be easily modified. How many buyside traders do we know that operate strictly in reactionary mode, slouched in their seats waiting for an order? The fund manager is paying millions of dollars for zero value add. With outsourced trading the manager doesn’t pay for it unless its utilized, and if the PM finds value in it they will continue to use it. If not, the PM can move on to a more suitable outsourced provider without going through the painstaking process of employee turnover. An outsourced trading platform that is structured properly can scale with an asset manager as they evolve and provide bespoke solutions to help them meet growth goals. Additionally, as mentioned above, with the right provider and trader, the PM can leverage their experience and relationships to gain access to liquidity and information which ultimately lowers the implicit costs of execution.
GW: For Europeans, compliance with MIFIDII’s best execution requirement is a critical box to tick. The same with Americans and SEC Rule 606. What benefits does outsourced trading have here?
BA: Regardless of a fund’s requirement to adhere to MiFIDII, all buy-side firms, wherever they are based, are competing with EU firms for investment mandates and will need to demonstrate to prospective investors how the activities of their trading desk are supervised for risk and best execution. Every investment transaction has associated costs, whether that is market impact costs, commissions, or taxes. Once an order is communicated, the best execution process begins; pre-trade analysis (assessment of trading conditions), pre-trade strategy (broker and trading tactic selection) and dynamic trade implementation (adjustments to the strategy during the trading process). Finally, data is collected to continuously improve the trade process and monitor for risks. This analysis, data collection, and process improvement is expensive and typically only exists at the larger more sophisticated funds who are willing to spend resources on trading technology. A best of breed outsourced trading firm will have these processes in place so the client can co-opt them to meet investor expectations and improve execution.
Interestingly, if one were to examine outsourced trading firms’ SEC 606 disclosure reports they would find some valuable information. In general, the majority of outsourced trading firms route somewhere between 50-to-100% of their non-directed orders to a financially incentivized venue or broker, whether it be their clearing broker or other payment for order flow third parties/HFT firms. The 606 reports are providing insights that I don’t believe many funds bother to look at prior to the selection of their outsourced trading counterparty. In our opinion, a true buy-side offering would only route orders to the client’s execution counterparties as an authorized trader of the fund.
GW: Critics would say that the risk of outsourcing trading is too high, given the difficulty in policing the potential sharing of information within a provider. What should hedge fund managers be looking for from their providers to ensure this risk is mitigated?
BA: I agree the risk is too high not to do serious due diligence. First, and foremost, managers should look at their provider’s structure and ask the following questions: Is outsourced trading their primary or sole source of revenue, or is it just another arm of a larger parent company? To what degree are the institutional and outsourced trading desks separated? Has the outsourced trading firm eliminated all conflicts of interest and removed moral hazard risks? Examples include the ability to use a fund’s information to their company’s benefit, crossing client flow internally with other outsourced trading desk clients or the firm’s institutional sales trading desk clients.
The provider’s SEC 606 or RTS28 will show which brokers/venues they execute their non-directed orders with. It’s a red flag if the majority of these orders are being executed through their clearing brokers or firms that provide order flow incentives. Long-story short, fund managers need to look under the hood to identify how a fund’s information or order flow could be used to their detriment and the provider’s benefit. A deep dive into the policies or procedures should flesh out what has been implemented to avoid conflicts of interest and ensure orders are executed in the client’s best interest 100% of the time. I would also encourage fund managers to visit the provider’s trading desk; you might be surprised by the proximity of some outsourced desks to the sales trading desks.
GW: Another risk is that the hedge fund manager has no control over the people assigned to it by their outsourced trading provider. Again, what questions should hedge fund managers be asking of their providers here?
BA: The fund manager should always be asking, “who is trading for me and who can see my orders during the entire lifecycle of the trade?” Does the provider offer a dedicated trader and backup who as documented authorized traders of the fund are the only ones that can act on its behalf? Delivering exceptional service means cultivating long-term partnerships though trust & uncompromising integrity. It’s critical that a hedge fund manager knows exactly who handles and has access to a fund’s most valuable assets. I am confident a fund’s investors would be extremely uncomfortable in any scenario where this was not the case.
GW: Outsourcing certain functions in any industry creates potential conflicts of interest. What are some that hedge fund managers need to get comfortable with in outsourced trading?
BA: A hedge fund manager should never be comfortable with potential conflicts of interest; they should be as confident as possible that the outsourced trading provider has done everything in its power to eliminate as many conflicts as possible. Many firms tout a conflict-free motto but when you dig a little deeper, they start to become suspect. Some red flags include:
• “[We are] employee-owned and has no proprietary book and therefore no [sic] conflicts of interest when we trade.”
• “We do not compete against the sell-side in any of their core businesses. This singular focus removes all potential conflicts of interest that would limit our access to liquidity”
• “Trades are executed on an agency basis ensuring the interests of the outsource desk are always aligned with those of clients.”
• “High touch execution on an agency basis, constantly endeavouring to align ourselves with your interests”
Employee-owned and lack of a proprietary trading book in no way eliminates all the potential conflicts of interest when trading. Similarly, executing trades on an agency basis does not even come close to guaranteeing the interests of the outsourced desk are always aligned with the client. If a firm has removed all of the conflicts of interests when trading, and their interests are always aligned with the clients, why do the majority of the outsourced trading firms’ SEC 606 Disclosure Reports show that somewhere between 50-to- 100% of the time their non-directed orders are sent to venues/brokers where they receive payment for the order flow or at a minimum provide the lowest or no execution costs which is not necessarily passed, or transparent, to the client? Again, the hedge fund manager needs to be analysing the disclosure reports and challenging their provider, or prospective provider, in these situations to make sure they understand how their orders are being treated.
GW: Finally, Ben, tell us about a few of the trends in the outsourced trading industry that you see either developing or growing in the next 12-18 months.
BA: Obviously we are seeing more and more traditional broker dealers entering the space hoping to provide their prime brokerage clients with a trading service. I think given the number of offerings that are coming available, managers will have to take a deeper dive into what each provider is offering and how the services are differentiated. I expect we’ll see the more sophisticated funds gravitate towards the truly full-service conflict free providers, while the majority of smaller emerging managers will stick with bundled PB type offerings. I also think you will see a shift towards fund managers partnering with “one-stop” shops that provide them a conflict-free alpha model trading desk as well as a middle-back office solution. The solutions may include software and services such as an OMS, PMS, portfolio management accounting system, shadow book NAV, risk analytics, and the full middle-back office support that is needed. The entire suite is a fraction of the cost of what it would cost an asset manager to build out and maintain with internal human capital themselves, and they receive a premier level of service and sophistication.
At the end of the day, its important for asset managers to understand not all outsourced trading firms are the same. Performing a well thought out due diligence program and finding a platform that strikes the proper balance between filling the fund’s most important needs and keeping their interests perfectly aligned is imperative.
Benjamin Arnold is the Founder and CEO of Meraki Global Advisors
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