February 2012

BUYSIDE DEALING: At the limits of outsourcing

RoadOutsourcing would normally stop well before it reaches the dealing desk. But Nicholas Pratt finds that factors such as pressure to expand internationally are fuelling more discussions. Outsourcing has been widely accepted by investment management firms but with a caveat that some functions would always remain in-house. Over the last decade, there has been a gradual creep in terms of the tasks that managers are willing to entrust to a third party – from the most prosaic back-office burdens to the more intimate customer-facing, front-office functions. There is now an increasing number of outsourcing discussions taking place around securities dealing. And a growing number of providers is moving into this space, only too happy to help. In the hedge fund world and among smaller asset managers, the use of third parties for dealing has long been an accepted practice, but for the larger, more traditional firms that have already invested in their own internal dealing desks, would the idea of entrusting the execution of portfolio managers’ carefully considered trades be too much to countenance? According to Clare Vincent-Silk, principal, operations, at asset manager consultant Investit, there is still a misunderstanding in fund management as to what exactly outsourced dealing services entail and what potential benefits are on offer. “It is about how to improve the dealing function and make it more effective and efficient rather than simply offloading the function to a third party,” she says. Vincent-Silk compares the market for outsourced dealing with the market for operations outsourcing ten years ago. “There is not yet an established model, thus buy-side firms have to carefully consider why they are pursuing outsourcing, what they hope to achieve from it, and what assets will be involved. It is not primarily about cost-saving but about better positioning the company to cope with growing complexity and scale of the dealing function.” She adds: “When we looked at the appetite for outsourced dealing three years ago, we didn’t feel that many institutional investment managers would consider it. “But in the intervening three and a half years, the industry has had to reconsider many things within an operational context. Fund managers are assessing the most cost-effective operating models for all their functions, including dealing.” Overnight orders
Furthermore, the challenges that existed for dealing desks back in 2008 have become more acute now in 2012. For example, fund managers are looking to expand into new asset classes and new geographies in search of returns. Those with a centralised dealing desk in London will have to consider whether to leave their orders with a broker overnight if they want to run emerging market funds. Otherwise they could have dealers working through the night, or set up a new dealing desk in another part of the world. In the United States, there are firms such as Williams Trading and Greenwich Prime Trading Group (GPTG) that have been providing outsourced dealing services to fund managers for more than a decade. Typically, the focus has been on small asset managers and hedge funds without either the assets or the trading activity to warrant a full-time team of traders of their own. But according to Barry Savitz, GPTG president, larger funds are also interested in outsourced dealing. “They recognise that it is a great way to cut overheads and turn a fixed cost into a variable cost. In the current environment, many portfolio managers do not know what their trading activity will be from day to day so our service gives them both scalability and flexibility.” To emphasise the fact that an American trend is finding favour in Europe, GPTG has recently linked up with France-based Exoé in order to offer US clients access to European stocks and vice versa.  Clients’ orders are sent via a dedicated link to Exoé which then executes these orders according to their clients’ list of brokers and investment preferences. “We are legally transparent, we trade in our clients’ name and we do not clear or settle trades,” says Franck Chatillon, executive committee member and head of development at Exoé. “We organise the execution process; we defend the clients’ interests in the market and we take on the regulatory and reporting burden.” Exoé has been running for five years and this year Chatillon expects the business to double in size and to include a few bigger asset managers, above the €10 billion assets mark. “What we expect among the big names is that they will look for an outsourced dealing service for particular asset classes where they don’t want to invest in new technology. For example, they may see FX [foreign exchange] as a commoditised asset class used purely for hedging rather than generating alpha and thus not part of their core activity.” One of Exoé’s clients is France-based Mandarine Gestion (MG), a boutique manager with €1.5 billion in assets under management, a specialisation in European stock picking and 20 employees in total, including five fund managers. The objective of outsourcing was to externalise the task of seeking best execution but enable the managers to maintain the relationship they have with brokers in terms of procuring research, says Rémi Leservoisier, MG’s managing director and chief operations officer. “We are able to gain up to 40 basis points improvement in execution price and because we are not a huge asset manager and because Exoé is able to consolidate its trading activity with other Exoé clients, we are able to access liquidity we would not ordinarily get access to.” The final benefit is the ability for MG to focus on its core competency. “Our job is to be good stock pickers rather than developing complex trading tools.” Immature market
So far, examples of large asset managers replacing their internal dealing desk with an outsourced service are very thin on the ground. ING Investment Managers (Americas) has outsourced its overnight trading to agency-only broker Instinet, but any examples of wholesale outsourcing are, so far, limited to small to mid-sized managers. The immaturity of the market is also underlined by the diversity of the providers and their respective business models. Alongside the independent specialists that offer only outsourced dealing, such as GPTG, Exoé and Williams Trading, are those that have extended their existing outsourcing services. This includes execution-only brokers (such as Instinet), investment consultants (such as Russell Investments) that provide transition management, and asset servicing firms (such as BNP Paribas Securities Services) that offer back- and middle-office services. BNP Paribas Securities Services is one of the few European asset servicing firms offering an outsourced dealing service, which became separate in 2007. But it has been in the past three years, and in the wake of the merger with Fortis Investments, that the service has really focused on external clients in addition to acting as the buy-side dealing desk for BNP Parbias’ own investment, insurance and wealth management divisions. The service has since expanded to include collateral and liquidity management. Despite the different business models, all the providers are agreed on one thing – the importance of remaining broker-neutral. “We take clients’ broker-lists at face value and look for best execution within that list,” says Philippe Boulenguiez, the head of dealing services. “We bring some added value in that we know the broker community well and if the client asks us for advice in reviewing their broker lists, we can provide various statistics based on their executions, but we do not get in the way of the relationship between the client and their brokers.” Sales strategies
Some providers may well need help with business pitches if large asset managers are to take them up. The first rule is to not sell your services to the very people you are looking to replace. “We had a request for a meeting from someone we assumed was a broker,” says Paul Squires, head of dealing at Axa Investment Management. “But they turned up and proceeded to pitch their outsourced dealing service to us.” Convincing a turkey to not only vote for Christmas but also pay out for a roasting dish and carving knife has rarely been a successful sales strategy. More importantly, though, Squires does not believe that outsourcing maximises what a trading
desk can provide. “What you lose is the personal touch between the fund managers and the traders. I know our traders would not want to hand over to someone they could not have a dialogue with.” This is not to say that internal dealing desks should be complacent about their continued existence, says Squires. “I think it’s fair enough for internal trading desks to have a bit of pressure.  I can’t imagine a portfolio manager telling their traders that they are so bad they want to outsource, but I can imagine a COO [chief operating officer] looking at the cost of a dealing desk, along with the cost of every other part of a firm, and deciding that it may be cheaper to outsource.” Outsourcing providers will argue there is more to it than cost; there is also the benefit of new pools of liquidity. They could also argue that many internal dealing desks are operating in a quasi-outsourcing manner already. First was the shift from having dealers sitting alongside portfolio managers to working on a centralised dealing desk. Now the majority are set up as separate legal entities, albeit for internal governance and departmental charging purposes. So, is it really that much of a leap for these desks to take on external as well as internal clients? Ultimately, the decision to outsource securities dealing may come down to how the function is perceived by an asset management firm: is dealing a core part of the investment process and, therefore, part of what defines an asset manager? Or is it merely an operational process that must be subjected to the same economic examination as every other operational process? And in the months and years to come, it will be fascinating to see if these philosophies and principles are maintained in the face of continuing competitive, operational and commercial pressures. ©2012 funds europe

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