Passive Investing Pushes Back-Office TCA
The buy and sell side have been improving the efficiency of their back offices in preparation for the industry’s migration to the T+2 settlement cycle, which begins on September 5, but the growing adoption of passive investment strategies has increased the pressure to bleed out further back office inefficiencies.
In 2016, $236.1 billion flowed into passive index funds and ETFs while actively managed funds while actively managed funds saw $264.5 billion in outflows, according to a CNBC report.
Although passive funds and ETFs have lower management costs than actively managed funds, their expense ratios are higher than their counterparts.
Over the past year, Scott Kurland, managing director and co-head of Workflow Technology at ITG, has seen the buy side peel away each layer of the onion looking for greater efficiencies.
“Managers are starting to break down all cost components of trading and not just in the front office but in the middle and back office too,” he said. “I use an analogy: You can continue sharpening the pencil on the front end, but if you don’t empty the pencil sharpener at some point you wind up with a giant mess of scraps that someone has to clean up, or eventually the pencil sharpener stops working.”
As part of this trend, some asset managers are taking a more holistic view of transaction cost analysis and are starting to include variables like settlement costs into their TCA calculations.
If an asset manager has one or two brokers who stand out due to their poor settlement processes, those issues will bubble up over time and lead to the asset manager assessing what impact the settlement issues affect the cost of the trades and ultimately the fund’s performance, Kurland noted.
“The operations manager may realize that one broker caused 17 fails and $X in cancel, correction and borrow fees in a quarter and decide to have a conversation with that broker or pull back the firm’s trading from the broker if it doesn’t improve its process,” he said. “I also may have a similar conversation may on the custodial side if they are equally as inefficient in their process.”
Kurland doubts that such performance data has yet to find its way into a broker vote, but it is finding its way onto the asset manger’s radar screen.
“If there are cost savings to be had that can impact a fund’s expense ratio, or even more so, costs savings that can affect the end client accounts directly, I think managers will start looking at those much more closely,” he said.