Institutional asset managers are increasingly turning to outsourced trading desks to meet the challenges of heightened best execution requirements, market structure changes and shrinking commissions, a new report by Greenwich Associates reveals.

The report, Outsourced Trading: Helping The Buy Side Improve Execution And Enhance Operational Efficiency, was released this week and shared at the Equities Leaders Summit in Miami. It captures the sentiment of U.S.-based investment professionals towards this growing industry.

Of those who had used an outsourcing partner for some or all of their trading, the in-depth survey found satisfaction was extremely high, with 71 per cent saying they were “extremely satisfied” and 29 per cent saying they were “very satisfied” with the service they were receiving.

Not only for hedge funds

An outsourced trading desk is a brokerage firm that is structured to act as an extension of a buy-side trading desk. Until recently, they had often been associated with hedge funds or emerging managers. But Greenwich Associates spoke with some larger investors, including some managing over $20 billion in assets, that now work with outsourcing partners.

“The genesis of the business was providing a trading resource to managers at launch who chose not to have their own in-house traders,” said Aaron Hantman, the chief executive officer of Tourmaline Partners, one of nine outsourced trading firms mentioned in the report.

“Outsourced and supplemental trading are now starting to scale simply because there are a lot of other forces in the marketplace, both on the buy- and sell-side that are leading brokers and managers to think about their cost structures and the ability to lean on experts in other facets of their business”.

Meeting buy-side challenges

Richard Johnson, a vice president in the Greenwich Associates Market Structure and Technology practice who wrote the report, said managing a buy-side desk of any size was now “a lot more complicated”.

“Beyond just trading, investors now have to do transaction cost analysis, manage due diligence, manage research, manage a team and all their commission sharing agreements,” he said.

“The market has moved on, and if some buy side firms out there dismissed using an outsourced trading desk previously, it’s probably worth taking another look”.

The report revealed that those using an outsourcing partner found value in its ability to provide additional trading support (47%), the potential for cost savings (33%) and improved execution performance (26%).

Nearly 70% of survey respondents, most of whom had assets under management of less than $10 billion, identified difficulty generating meaningful commissions for all of their brokers as one of their biggest challenges.

“Equity Commissions are down 45% since 2009. When you add in the impact of passive management, increased regulation and advances in trading technology, one can understand why both the buy- and sell-sides are thinking more critically about managing their costs,” said Hantman.

Respondents also saw using an outsourced service as a way to circumvent a trend towards “juniorization,” a trend that has seen brokers replacing senior sales staff with less expensive, less experienced staff.

“In terms of headcount and manpower, juniorization looks like a like-for-like comparison, but what you lose is the experience and the relationships that the more senior, more expensive folks had,” said Johnson.

Expanding reach and access

Survey respondents with experience using an outsourced trading desk were also enthusiastic about gaining access to liquidity.

“The average smaller buy side firm manages 20 broker relationships and a really big firm only manages about 40 broker relationships; an outsourced trading desk could have up to 300 different broker relationships who are going to have a much better picture of overall liquidity on the Street,” Johnson said.

One in five investors (20%) named “special situations” as a reason for engaging outside help. This included concerns about how they could expand their investment universe internationally.

More than 50% of respondents were worried about complying with international regulations, while 44% were concerned about how they could gain local market expertise. For 27% of the survey’s respondents a single connection to an outsourced trading desk was able to solve these twin challenges.

The same applies to derivatives investments, with appetite for this asset class increasing amid current market volatility. “A smaller fund that has just one or two traders might not have the skill set to trade a completely new asset class, and it make sense to outsource to experts who can do it,” said Johnson.

A growing sector, but choose your partner wisely

Despite institutional investors now showing more interest in outsourced trading desks, some firms have remained resistant. More than two-thirds (69%) of respondents who don’t use outsourced trading cited a desire “to retain control of order flow” as the reason.

“You hear ‘outsourcing’, and a frequent reaction is that this means handing over the responsibility and the handling and the function to another party,” said Hantman.

“In fact, when we talk about supplemental trading, we are working with a trader, we’re expanding their reach, we’re working directly with them in following their rule set, their compliance set, putting orders to work in the manner that they want, depending on what their investment strategy is and whether they want anonymity or whether they want attribution.”

But a firm considering using an outsourced trading desk must take into account factors such as the corporate structure of the partner, whether it is independent or part of a larger broker-dealer and the breadth of trading tools and services that they offer, Johnson warned.

Being conflict-free is the “number one most important thing,” he said.

“We see some outsourced trading solutions that reside within integrated investment banks that provide research, banking and prime brokerage services. This presents a conflict. When an outsourced trading firm represents their client to the sell-side they should not be competing directly with the sell-side in their core businesses.”