Volatility Adjustment training pack from novices to experts
The Volatility Adjustment (VA) is the most widely used Long-Term Guarantee measure under Solvency II.
While investment companies have looked to outsource many back-office functions over the years, they’ve hesitated to do so when it comes to trading. Traditionally, investment decision makers have wanted to have trading teams in close proximity. But times are changing, and the industry is reaching an inflection point: cost pressures, efficiency of outsourcing and COVID-19 have all converged to make a compelling case for investment companies to reconsider outsourcing the trading function.
For investment companies around the globe, from insurance companies to pension funds to hedge funds, relying on outsourced trading firms should bring more efficiency to trade execution. These providers have the capacity to allow clients to scale up quickly, with trading desks around the globe, and can tailor execution to the specific needs and requests of fund managers. The growth of outsourced trading highlights how maintenance of an in-house trading desk is becoming more of a burden as the industry increasingly questions whether trading really rests outside of the core competency of investment management.
We could be at a tipping point. About 17% of asset managers have already outsourced trading, and another 37% plan to evaluate the practice over the next two years, according to a 2020 survey of 300 heads of investment operations worldwide by Northern Trust Corp.1 Another 31% expressed interest in outsourcing but without a specific action plan. According to research conducted by Sionic and BNP Paribas, 20% of investors have outsourced some of their dealing functions. Among those not yet outsourcing, 21% will be actively considering an outsourcing option within two years.2
Our own internal surveys of our customers and prospects also point in the same direction: those who have already outsourced don’t want to go back to their old ways. All of them consider outsourced trading either a positive development or a neutral one. Even in the latter case, they consider it a worthwhile endeavour because it frees up portfolio managers to focus on their core competency—finding ways to generate alpha through their investments.
As the outsourcing of middle and back-office functions for financial institutions is already a mature industry, the following nine factors are worth noting when considering the prospect of outsourcing trading operations:
1. Perceived need for proximity has faded. Before the pandemic, traders, portfolio managers and investors usually were in the same room together (or at least in the same building), exchanging ideas and holding on to the notion that this was the best way to conduct business. Yet the work-at-home shift due to COVID-19 has shown that communication between trading teams and PMs can be efficient even when team members are working remotely. To varying degrees, traders will still operate from remote locations. This should eliminate the longstanding psychological barrier of needing to have everyone in the same room.
2. Margin pressures continue. Despite mostly a bull market over the last decade, fund managers had been facing pressure to cut costs driven in part by the rapid growth of low-cost exchange-traded funds (ETFs). Many of these vehicles are passive with annual expense ratios of just a few basis points of assets. Even active ETFs can have expense ratios of less than 70 basis points compared with a typical mutual fund fee of about 1%. So to boost or even maintain profit margins, fund managers need to either generate more alpha or cut costs. With an in-house trading desk, trader compensation may average around US$500,000 a year according to some estimates. 3,4 By switching to outsourced trading, costs become variable, based on assets under management or trading volume.
3. Regulatory changes persist. Asset managers typically invest globally, and they must adhere to regulatory regimes of various jurisdictions. Rules are constantly in flux, requiring in-house staff to keep up with all of the changes. For the United States, the new administration will likely bring more changes for managers. In Europe, the Markets in Financial Instruments Directive (MiFID), which began to take effect in 2018, presented firms with significant compliance expenses with respect to trading. One of the benefits of outsourcing trading is that firms can offload the compliance burden to specialists.
4. Scalability brings benefits. Software-as-a-service across all industries shows the benefits of scalability and cost. With outsourced trading, firms have the flexibility to grow and introduce new products quickly without having to hire more traders just to keep up with volume or account for new investment structures. Fixed costs get converted to variable costs, which means expenses go down in the event of a market downturn or investor drawdowns.
5. Worldwide trading adds expenses. Investment mandates have increasingly called for exposure to international equities and alternative assets such as commodities, which means that firms need to have a trading presence in markets around the globe. Many financial products now trade 24/7, which would require staffing up in New York, London and Sydney. Firms can instead tap a partner with a trading presence on the ground globally, ready to execute orders at any time of the day. It’s likely a much more cost-efficient approach than maintaining trading staff worldwide.
6. Trader attrition presents risks. Competition for experienced traders means asset managers face a challenge in retaining talent. The hunt for talent is especially acute for specialised traders for asset classes such as illiquid products and derivatives. If an asset manager loses a key trader, time and money must be spent to find a replacement and then train the new hire on processes and procedures.
7. Fear of damaging broker relationships is unfounded. Fund managers often cite their worries about undermining existing relationships with brokers if they were to use an outsourced trading firm, but we don’t see that happening. Relationships won’t suffer, in part because brokers ultimately have relationships with clients, not traders. By going with the right outsourced trading firm, asset managers can leverage that firm's extensive relationships with banks and brokers, exchanges, futures commission merchants and market makers around the globe. That means potentially better trade execution thanks to a greater pool of liquidity as some outsourced trading firms provide access to 30 or more brokers and market makers, compared with perhaps a handful of them that a fund manager’s trading desk may rely on.
8. Tailored approaches bring more flexibility. There’s a notion that outsourced trading firms only provide a one-size-fits-all approach, but actually the opposite is true. These specialists can be quite flexible, and they have to be. In fact, outsourced trading firms typically improve execution efficiencies. These providers should be able to look at your processes and suggest ways to improve them in areas such as execution and trade life cycle, tailoring a solution to your platform and strategies. Outsourced trading services typically include order processing, settlement and other customisable middle and back-office reporting and operational workflows.
9. Trading desks typically don’t add more relative alpha. Some hedge funds and other asset managers insist on keeping the trading function in-house, citing the trading desk as a source of alpha. However, we find that this may only make sense if the investment manager and trader is the same person as found at some smaller shops. For medium-sized and large firms, trading desks generally do not have a goal to generate alpha beyond what an outsourced firm can do. In either scenario, trading should just focus on the most efficient execution of an investment idea.
All of the factors above present a compelling case to adopt outsourced trading. Demand for the service will likely rapidly increase in the years to come as asset managers face more costs and constraints due to regulatory changes and continually evolving global markets, while having a harder time justifying the case for eschewing efficiencies that can be provided by domain specialists.
Asset managers also do not need to move all trading operations beyond their walls overnight, but can take a step-by-step or piecemeal approach. Doing so at a minimum will allow managers to manage costs better and better position themselves for the structural changes under way in the investment industry. Outsourced trading will also enable fund managers to focus on their core competencies of investment strategy and alpha generation, while significantly reducing the burden and costs associated with technology and operations.