Outsourced Trading: You Need To Have The Right Pit Crew
(Reprinted with permission from Hedgeweek)
Ayrton Senna was arguably the greatest Formula 1 racing driver of all time but he never needed to worry about the brake systems or the engine firing on all cylinders. His job was to get behind the wheel and drive faster than the competition.
By analogy, today’s hedge fund manager has increasingly come to recognise that there is no point trying to handle every aspect of running a hedge fund. A range of tasks, from compliance and middle-office reporting to administration and IT services are being outsourced so that the portfolio manager can focus on investing without distraction.
This outsourcing trend has in recent years increasingly extended to the trading function, with managers of all AUM sizes choosing to avail themselves of the services provided by a professional, buy-side calibre trading desk, which enhances the investment process while at the same time reducing their operating costs. One firm that is seeing tangible benefits from this trend is Cowen Prime Services LLC, whose Global Outsourced Trading Group (“Cowen”) provides a full-service, global, multi-asset class execution and support solution to the buy-side community.
Its aim is quite simple: to become a trusted partner of a hedge fund manager’s business and essentially serve as an extension of that firm.
“It has become increasingly more difficult for hedge fund managers to raise capital,” says Mike Rosen, Global Co-Head of Cowen Prime Brokerage. “Institutional investors expect managers to employ recognised systems and technologies in the operation of their businesses before they will consider allocations to them, and managers are expected to bear the cost of supporting such infrastructure even as the fees they earn have compressed. What outsourced trading allows a manager to do is to convert what would otherwise be a fixed cost into a variable one that can be managed on a pay as you go basis.”
Moreover, there is a clear benefit of scale to outsourced trading that most hedge fund managers, aside from those managing billions of dollars, would not be able to achieve internally. Cowen’s outsourced trading desk is already connected to more than 100 executing brokers and more than twenty-five prime brokers and custodian banks on behalf of its clients. Factor in the collective global experience of Cowen’s trading team, many of whom have worked previously for buy-side institutions, and the wealth of information they have at their disposal, and one begins to appreciate why outsourced trading has become an important option for today’s hedge fund manager.
The Cowen proposition
Cowen’s Global Outsourced Trading Group consists of several trading teams located across the US with offices in New York, Stamford, San Francisco, and Atlanta, as well as internationally in London through its affiliate. The service will be up and running in Hong Kong shortly as well.
Throughout the trading day, thanks to the extensive technology architecture built within Cowen Prime, the outsourced trading team provides full transparency during the entire trade lifecycle, from the time the portfolio manager sends an order to the time the trade is executed. The life cycle of the trade is then completed with the transmission of the end-of-day files to executing brokers and prime brokers, and finally the uploading of beginning of day positions to all of the requisite trading systems.
Edwin Leon, Managing Director who oversees the outsourced trading team in the Stamford office, says: “In many cases, the service extends to interacting with our clients’ support staff, investors, and administrators to assist in the reconciliation process. There has to be a high level of trust for clients to give us that capability to work on their behalf.”
“In addition to trading, we provide additional operational support, including account opening with brokers, deployment of trading systems, trade-break resolution, as well as a complete set of shadow books and records using our portfolio accounting and reporting technologies,” says Rosen. “And unlike most other outsourced trading firms, we have the capacity, and our clients allow us, to view their portfolios in real time, which in turn allows us to serve their needs as a trader much more effectively. “All of these services allow us to function as a true partner to the manager and an extension of the manager’s front office as compared to other outsourced trading entities that do not offer these services and often only trade with the Street on a broker to broker basis – which we believe is much less desirable to both the investment manager and executing broker.”
One of the hallmarks of Cowen’s outsourced trading solution is the deep level of trust between its traders and the end clients. To achieve this, Cowen spends a lot of time with prospects to understand their specific business needs. This includes understanding the investment strategy in detail and working with the manager to tailor the solution to the specific client’s trading style. As Jack Seibald, Global Co-Head of Cowen Prime Services, stresses: “It is incumbent upon us to understand, in detail, how a manager thinks about the investment process and what relationship he’s used to having with traders. What kind of portfolio reporting he’s used to. How he prefers to monitor the portfolio during market hours, and so on. The technologies we employ allow us to tailor the solution to pretty much any of the client’s possible needs as it relates to trading activity and portfolio reporting.
“Once we have a good understanding of the client’s needs and preferences, we can suggest how best to set up the manager, which OMS/EMS solution might work best for his needs, which one of our trading groups might suit them best (sector specialty, geography, etc), and which lead trader is likely to be a good fit, personality-wise.”
Another feature that sets Cowen Prime apart is that its outsourced trading model is an agency only model. Cowen Prime operates in its own broker/dealer and is completely independent and legally separated from Cowen Inc’s other trading businesses. This protects clients’ interests, and ensures that best execution is always front and centre during the trading day when handling each client’s trading needs.
Typically, clients will initiate an order, at which point the trader and his team determine which broker should execute the trade. Trades are allocated based on an established commission budget the client has set and/or any other needs that may arise, such as liquidity.
“Once initiated, the client has full transparency of the order, including which broker is working it and how and when every fill occurs,” explains Leon. “On the flip side, the executing broker will know at the time the order is received which client it is coming from. All of the trading connections are set up in the client’s name, so there’s never a question about who the customer is. This reinforces the client’s brand, as Cowen is not interposing itself between the client and the executing broker.”
This benefits both the client and the executing brokers as each has full transparency at all times. “We believe the fact that the trades are sent out in this fashion also helps the manager to build its franchise with the Street much more so then in a broker-to-broker outsourced trading model,” adds Leon.
An extension of the manager
As far as the brokerage community are concerned, Cowen’s traders operate as if they were the manager’s own trading team. Based on the systems and services offered by Cowen and the level of transparency in the model, Cowen’s outsourced trading solution is much more than just an agency-only execution model. “We try to be an extension of the fund manager and make sure their interests are served to the best of our ability,” says Rosen.
Brokers appreciate the level of transparency that Cowen provides and understand that the outsourced trading desk controls the relationship as the authorised traders for the respective portfolio managers. They quickly learn that the information flows via the traders to the managers, and they trust that they will have orders directed to them from our trading desk based on the value that they provide to the managers.
“Overall, this helps engender trust that we’ve asked our outsourced clients to put in us. We give them the tools that enables that trust, but also allows them to verify our performance,” remarks Seibald.
When Edwin goes out to meet brokers or new fund managers, in many cases they know him as the trader for X hedge fund, and as Rosen points out: “This endorses what we do. We are dispensing more than a hundred million dollars in commissions to the Street where we have excellent access to brokers and outstanding relationships. We look to prove that our outsourced trading solution is lower cost and affords the manager a better ‘all in’ package than they would otherwise get if they hired one or two traders and operations personnel internally. The majority of our clients (c.80 per cent) outsource their entire trading activity to us.”
Although Cowen Prime Services offers prime brokerage services alongside the outsourced trading solution, many of its outsourced trading clients are large and more institutional in nature. As such, they typically already have prime brokerage relationships in place with the likes of Goldman Sachs, Morgan Stanley, JP Morgan, etc. Rosen says the outsourced trading solution works well when “we are integrated with other prime brokers. We have over 20 different prime brokers and custodians integrated into our systems.” In terms of executing brokers, Cowen trades with whomever the manager directs it to trade with, based on the value of the services they are getting from that brokerage firm, such as research coverage, sales coverage, corporate access, earnings models, analyst visits, etc.
“We are in continuous dialogue with our clients, offering our input on how each broker is performing on the quality of their execution, the attentiveness to the client’s needs, and on the market colour they provide, but ultimately, it’s up to the portfolio manager to determine which brokers they value and want to maintain relationships with,” clarifies Leon.
Trust and transparency
Broadly speaking, the AUM sweet spot of the typical client Cowen trades for is between USD250 million and USD1.5 billion. That said, regardless of whether someone has USD100 million or USD5 billion in AUM, there’s no difference in the offering.
“We view every client as a partner. We had one fund that started with USD200 million that grew to USD1.5 billion in AUM. This has been a relationship that we’ve built over time and at no time did the manager consider hiring traders or an operations team. Regardless of the asset size, the asset class, or the investment strategy, there is no differentiation in terms of the service level a client should expect to receive,” says Leon.
When Cowen enters into a new outsourced trading relationship, the portfolio manager could have up to 20, 30 or 40 brokerage relationships that they wish to maintain. Cowen will review these relationships with the client and go through a budget to determine what each broker could expect to receive in commissions “and then it is our job over the course of the year to make sure we hit that budget,” adds Leon.
“On a day-to-day basis, it’s not as if the portfolio manager is telling us who to trade with. They give us the trades and we make sure that those orders are sent to the appropriate brokers the client has established relationships with. It’s one less thing for the portfolio manager to worry about. We manage the commission process on their behalf so they can focus more on the portfolio.”
High quality reporting
High quality reporting is a key aspect of the relationship. Mangers receive a suite of daily profit and loss, portfolio appraisal, activity and MTD and YTD commission reports. On a pre-agreed schedule throughout the year, Cowen’s trading team will review commissions in detail. Where the manager stands relative to their commission budget will be a big part of the ongoing conversation, but the trading team will also discuss how each brokerage firm ranks relative to others from a trading perspective.
“Oftentimes the trading team will remind managers of an upcoming event that is likely to be important to them, so as to make sure the manager is doing enough business with that broker leading up to the event,” explains Seibald. The view taken by Cowen when rolling out the Global Outsourced Trading Group was to bring all of the prime brokerage solutions it had developed at Cowen Prime Services to the table to benefit its outsourced trading clients. This could not be done, however, unless portfolio managers trusted Cowen to grant it access to their prime brokerage accounts. Over time, that trust has been earned such that Cowen can provide the kind of reporting services fund managers wouldn’t ordinarily get with other outsourced trading desks.
“We are in possession of all executed trades, so in addition to managing the end-of-day file transmission process, we also have the ability to provide end-of-day “flash” profit and loss and position appraisal reports for the Managers. We then do a “true” reconciliation overnight so that when the manager walks into the office the next morning, all of the trading systems have already been populated with the trade data that our team has reconciled back to the various PB accounts.
“The managers give us a limited trading and operational authorisation to do this on their behalf and trust us to work with their client service representative at each prime. Over time, our clients’ prime brokers have learned to appreciate that there is one centralised desk handling things correctly,” comments Seibald.
A typical day in the life of an outsourced trader
Typically, the start of each day for Edwin Leon and his team involves going through each client’s portfolio to ensure everything has been reconciled correctly from the previous trading day and that there are no unresolved trade breaks or settlement problems. Next the team dissects each client’s portfolio, looking for research news that it can pass along to the portfolio manager and bring to their attention any events that might have occurred, be it stock-specific, sector-specific or macro in nature that could impact the portfolio. As the markets open, each manager sends over their orders and Cowen starts layering them into the system. “We are in constant dialogue with the executing brokers as the orders are worked and make sure we keep all of our portfolio managers up-to-date on everything we are seeing in the markets,” outlines Leon.
When the markets close, Cowen allocates trades to the client’s prime brokers in conjunction with the operations team at Cowen, transmits those allocations to the executing brokers and then transmits files to others that may need them, such as administrators. “Critical to the job is making sure we are always monitoring news flow, staying in touch with our network of brokers and monitoring the quality of executions. Essentially, we serve as the extra set of eyes and ears for our clients in an effort to ensure that their expectations are met or exceeded,” adds Leon.
Cowen’s outsourced traders’ many years of experience, combined with highly sophisticated systems they employ, allows them to create customised procedures and solutions for handling all of their clients’ needs in a highly efficient manner. It’s all about trust, value and an exceptional, unparalleled level of service that they provide every day.
Portfolio manager perspectives
John Tompkins is the founder of Chicago-based hedge fund, Tyvor Capital. When the fund launched in 2013 it was just Tompkins and his analyst and as Tompkins says, “we wanted to outsource everything, including trading”. Over the past five years, Tyvor Capital’s AUM has grown from USD250 million to approximately USD1.1 billion and Tompkins has no plans on changing the outsourced trading arrangement with Cowen, who he says “do a solid job on the execution side of things”.
“I have coverage from pre-market hours to after-market hours,” says Tompkins. “In addition, Cowen does all the reconciliation, trade breaks, it helps me with any performance reporting that I might want and helps me maintain contractual relationships with my prime brokers. Overall, from a compliance standpoint, the outsourced trading group is a well buttoned up shop.” Another one of Cowen’s outsourced trading clients with more than USD1 billion in AUM is a fundamental, research-driven equity long/short investor, who asks to remain off record. Speaking about many of the value-added services, the manager refers to the fact from a reporting perspective, Cowen Prime uses Advent Geneva; an institutional accounting system typically beyond the reach of small to mid-sized managers.
“As a client we get to use Geneva reports that Cowen’s back office uses to populate our trading systems. Everything is so well orchestrated that it almost acts as an extension of our middle-office functions, even though it wasn’t intentional. “Cowen’s back office team sends us the trade reports out of Advent Geneva and reconcile everything to identify trade breaks, which makes our reconciliation process highly efficient. We receive very robust reporting through Geneva using the web portal, which allows my COO to do analysis on the profitability of trades. “Investors care about these things too. Because these processes are used as a part of Cowen’s trading services, investors are not paying additional for all these add-ons with their commissions. The fact it is free is simply because Advent Geneva is already part of Cowen Prime’s system architecture to provide the trading services.
“The only thing Cowen charges us for are commissions on the trades that are executed through its broker/dealer. From our investors’ perspective, those are by far the lowest cost trades and are significantly lower than what we would pay for any other broker. Thus conceptually, it is in our investors’ interest, to execute the majority of our trades with Cowen. “We can’t do that as we have research needs and so on, but once our investors understood the fee structure, they became a lot more comfortable. If we brought the trading function in-house, we would not be able to replicate the price-per-trade that we have with Cowen Prime’s broker/dealer. Our investors would end up paying a higher average brokerage cost per trade,” explains the portfolio manager.
When speaking to Cowen’s outsourced trading clients, the common consensus is that by going down the outsourced route, it frees them up to focus on running the investment strategy. As Tompkins emphasises: “My overall objective is to run a business where as much of my time as possible is spent looking at stocks. This has been one of the biggest benefits to using Cowen. They give me the time I need to focus on stock selection.” The equity long/short manager believes Cowen does a good job of not getting in the way of the relationship he directly has with the research sales people and Cowen handles all aspects of the trading relationship by communicating with the sales traders.
“As long as Cowen doesn’t try to change the relationship that I have with each of my executing brokers, then there’s no problem,” he says. “Some outsourced trading desks will send the trades over in their name and then at the month, they will go through and allocate what percentage is attributable to each particular manager. In that case, reconciling commission dollars at the end of each month can be a huge hassle.
“When Cowen sends them a trade, it’s my name that appears in real-time. They know exactly how many trades we are sending over, when we are sending them, there’s no accounting that they’ve got to deal with, and most importantly from an economic perspective, Cowen does not charge us for the privilege of sending trades to other brokers.” Tyvor Capital’s Tompkins says the one thing he has been most pleasantly surprised by is how little awareness he has of what Cowen does. It handles so many technical issues that Tompkins doesn’t have to get involved. This has helped create a work environment analogous to what he enjoyed working in much larger, sophisticated shops.
“Their level of sophistication is really solid and I think for someone who does what I do, that’s a valuable resource to have. When you work at firms like Citadel, they are so sophisticated that they have made it such that the portfolio manager and analysts only have to worry about picking stocks. “When you switch roles and start running your own business, only then do you realise how much you need to think about. And that’s why Cowen has played such a critical role,” says Tompkins.
Overcoming MiFID II ‘research unbundling’
Westminster Research Associates, an affiliate of Cowen Prime, has been providing commission sharing arrangement (CSA) services for more than 20 years and currently has in excess of 700 clients in North America. Westminster’s team works closely with Cowen’s Global Outsourced Trading Group to provide complementary services, in respect to commission management, to US clients.
Now, with MiFID II up and running in Europe, there is a significant opportunity for Europe-based hedge fund managers to leverage Cowen’s outsourced trading solution alongside Westminster RPA, a Research Payment Account administration service that helps managers comply with MiFID II research unbundling requirements.
“In an arrangement where a client decides to use Cowen’s outsourced trading desk and Westminster RPA, based on the level of trading with the client’s core execution counterparties, a series of RPA credits will be generated, which reside with the executing broker. Our team then sweeps the RPA credits into the client’s RPA account,” explains Chris Tiscornia, CEO, Westminster Research Associates. As Westminster is a sister company, it knows the client’s trading activity based on what the outsourced trading team has done with each of the executing brokers. That makes the reconciliation and RPA credit sweeping process a lot more efficient and removes the need for the client to supply Westminster with trade files.
“Clients use a flexible software package that we offer to manage the funding of the account as well as the budgeting and payment process. At the same time, clients work with a highly experienced team at Westminster Research to help them with the reconciliation process, invoicing trade funds, consult with them on any regulatory issues that they may be wrestling with and so on. “On a T+1 basis, all of the client’s trade activity will be populated in their account at Westminster. The client can go online and see all of the trade activity that was conducted by Cowen’s outsourcing trading desk over the previous day,” says Tiscornia.
For European managers, the ability to combine outsourced trading with a fully MiFID II-compliant research unbundling solution is an attractive proposition. Westminster RPA supports every type of funding model – the Swedish model (accounting charge), P&L funding, client charge and CSA sweeping of trade commissions. One of the key enhancements Westminster Research had to make for its RPA clients in Europe was the ability for them to set a budget by strategy “and then for us to have a series of analytical tools and reports that clients can automatically generate to work out how much they have paid to each of their research counterparties versus what they initially budgeted for,” explains Tiscornia.
“I think there will be elements of the research unbundling process under MiFID II that have, and will continue, to migrate to our US clients. There will be a need for them to have more rigour around the budgeting and valuation process for their research counterparts.”
The need for outsourced trading will likely continue to grow because managers are going to be closely looking at operating expenses. At the same time, the need for reporting and flexibility of research budgeting in the RPA space will also grow as the influence of MiFID grows stronger. That there is one company (one counterparty) supporting both of these business activities on behalf of hedge fund managers “is a pretty exciting proposition,” remarks Tiscornia.
While there are multiple benefits to outsourced trading, picking the right partner is vital. If portfolio managers don’t have a team that cares about more than just getting a trade done, they are not getting the full benefit of the offering, which in turn could have a longer term impact on the performance of their fund.
As Rosen concludes: “We have spent a lot of time, effort and thought in creating our outsourced trading solution. Based on our own experiences as portfolio managers, and by interacting with hundreds of clients over the years, we believe the offering we have created provides an unmatched value proposition in the market place, while at the same time benefitting our clients by focusing on each manager’s specific needs.”
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