As 2021 gets underway, financial markets are showing renewed signs of volatility. The CBOE’s VIX index, the world’s most watched volatility indicator, has surged yet again as markets have zig-zagged following a surprisingly resilient 2020.
Against this backdrop, many buy-side firms are reassessing their long-term strategies and looking at ways to ensure they can capture more value amid all the market gyrations. One of the ways they are doing this is by taking a closer look at the case for outsourcing or supplementing their trading desks.
More volatility equals more trading and a growing number of firms are discovering that in such an environment, outsourcing becomes even more attractive. Whatever reservations some buy-side firms may have had about replacing or complementing their own in-house traders, they are learning that the advantages from outsourcing – in terms of cost, performance, coverage and opportunity – are too clear and too numerous to dismiss.
The pandemic has essentially been a proof-of-concept for outsourcing trading desks. Both buy-side and sell-side companies have found that their traders could work remotely, without any significant loss of efficiency or performance. Put simply, the need to be able to see your trader at a desk a few feet away no longer feels so pressing. And amid all the cost pressures that firms face, this has led to a growing number of companies considering the outsourcing proposition.
At Cowen, we’ve received a barrage of inquiries from hedge funds and institutional investors, not only in the United States but also in Europe and Asia. They are keen to understand how outsourcing can work for them and why some of the long-term shifts in the market landscape favour that approach. Here are some of the factors we see influencing their decision-making in the year ahead.
The cost arguments for outsourcing have been around for some time, but in the past year they have come into clearer focus. The picture is more nuanced than might appear at first glance. The scale of the savings that are possible from an outsourcing arrangement vary according to the size of the firm and the nature of the trading.
One incentivising factor has been the dramatic increase in passive investing. This has been a global phenomenon, but like many market trends, it has been led by the United States. As of March 2020, passive funds accounted for 41% of combined U.S. mutual fund and exchange traded funds under management, according to a recent working paper for the Federal Reserve Bank of Boston. That was up from 14% in 2005 and from just 3% a decade earlier.
In a world where funds are so often passively investing, it makes increasingly less sense for a fund to employ some or all of its own traders given the prohibitive all-in costs. Those include salary and bonus, trading terminal, space and a host of other ancillary costs.
Another factor concerns the continued growth in cross-border trading. Any firm with exposure to multiple time zones has to consider the number of traders required to have adequate coverage. Going with an outsourcing provider means gaining enormous economies of scale.
For instance, at Cowen, we have more than 35 highly experienced traders in multiple locations who are trading on behalf of our clients. Employing people with those combined skillsets would be difficult for any firm other than the very largest of institutional market participants. Yet small- to medium-sized hedge funds and institutional investors are able to instantly take advantage of their skills and gain 24-6 coverage. Think of it like being able to recruit several players from Manchester United to play in a weekend five-a-side.
Outsourcing trading requirements is not only about substitution. It can involve complementing an existing trading team, giving it more reach in terms of asset classes or geographies. Some firms may want to retain their traders but add trading resources by outsourcing as the funds grow.
One further rationale comes from margin pressures. This, after all, is one of the main reasons so many executives are looking at costs in the first place. A recent report by Deloitte on the investment management industry noted that before Covid hit, fund managers were experiencing both the longest running bull market in history and shrinking margins at all but the most successful of management firms.
Falling margins have forced firms to consider every avenue when it comes to cost. The Deloitte report showed fund managers around the world looking to cut costs, with half of its survey respondents planning between 11-20% in the coming year.
Europe Comes of Age
Outsourcing has been common in the United States for many years, but it remains less appreciated in Europe. That has already begun to change. The United States benefits from a homogenous market and a general business approach that welcomes outsourcing. European asset managers, hedge funds and family offices, by contrast, have a more fragmented marketplace and historically adopted a more conservative approach to the idea of contracting out trading needs.
The cost and margin pressures noted above offer one incentive. In Europe in particular, the cost structure has changed as a result of MiFID II. But market practitioners detect a greater appetite for outsourcing for other reasons. The experience of the pandemic has changed mindsets about what is and what is not possible remotely. Virtual trading turrets have made it possible for traders to work from home or anywhere else. That in turn has made investment funds more open to new ideas and allowed an outsourcing education process to take hold.
Europe will be adjusting to a new environment with Britain now out of the European Union, although the agreement of a UK-EU trading accord means that radical change is not on the cards. The recent U.S. election has changed the market outlook significantly. Long-term investors are reassessing a wide range of issues, from fiscal policy and its impact on asset markets to the U.S.-China relationship.
Amid all of this, the biggest question facing markets is how the world will transition to a post-pandemic environment. This is a fraught question because the scope for uncertainty is so high. When volatility reached a peak in March 2020, few would have predicted that asset markets were about to embark on a massive rally. Similarly, now that vaccines are being distributed, there are major question marks about the different speeds at which countries can and will get back to normal and the abilities of governments to cope with both logistical and fiscal challenges.
These factors suggest that the initial burst of volatility seen in 2021 could be a harbinger of more tumultuous trading in the months to come. For smaller companies, this bolsters the argument for considering outsourcing because a trading desk provider can offer 24-6 coverage that new entrants and smaller hedge funds cannot match.
Multiple Asset Classes
Funds that have outsourced their trading needs historically have focused on equities. The information flows, reporting requirements and other factors have made equities suitable for swapping in the services of a third party. But most firms of any size trade diverse portfolios and could benefit from outsourcing their trading requirements in other areas.
Cowen, for instance, is pioneering outsourcing in fixed income. In this market, only the largest money managers get top-tier access to liquidity. For them, having in-house traders may make sense. For anybody else, there is not that same level of institutional market connectivity. That is especially important in the fixed income arena, where successful trading often comes down to relationships. An outsourcing provider with veteran fixed income traders can offer something that many managers could not build themselves, or at least not without heavy costs.
The picture is a little different for foreign exchange outsourcing for which we have experienced substantial growth in 2020. Appetite for outsourcing stems either from funds that want to complement their existing coverage or those that just do not have the manpower or expertise to recognise good pricing, aggregate liquidity or understand the nuance of an emerging market to ensure they are executing at the best price.
Trust and Acceptance
The biggest shift is likely to have less to do with asset classes, geographies, geopolitics or even costs. The way that sell-side and buy-side market participants alike were able to adjust to Covid-19 without serious market disruption has shown asset managers that there is nothing intrinsic to trading that means it must take place on-site.
At the same time, firms need to feel they can trust their providers to act like an extension of their own team. Cowen operates as an agency-only outsourced trading provider, which means that its clients know that the trading they outsource is done for their benefit and their benefit only.
Furthermore, the value of outsourcing in terms of business continuity has been clearly demonstrated. This explains why there have been increases in both demand and supply. Not only are there more firms moving to outsource their trading desks but also there are more providers offering such services.
What is clear from all of these issues is that a critical mass has been reached with regards to provision of trading outsourcing. In the coming months, we will be publishing a series of articles that drill down and look at some of these issues in more detail. It has been an exciting start to the year and we are already building on this momentum.
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