Decoding Outsourced Trading

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All outsourced trading services are not alike.

In the broadest sense, outsourced trading replaces some or all of the functions of an internal buy-side trading desk with a third-party provider—but as this fast-growing industry continues to establish itself as a critical part of the asset management landscape, it becomes increasingly important to differentiate between the various service offerings within the space. Here we take a closer look at three predominant models for outsourced trading, assess the strengths and weaknesses of each, and discuss several key considerations for asset managers working to identify the optimal choice.

3 types of outsourced trading service models

Services can be separated into three models, defined by their core characteristics.

1. Prime Brokerage / Custodian Model

To enhance their prime brokerage and custodial services in an increasingly competitive environment, custodians and smaller investment banks are offering outsourced trading. The buy-side client has a single relationship with the provider. The execution broker housed inside the provider, a.k.a “outsourced trading desk”, executes trades for the client and passes the execution to their settlement and clearing group. The clients are provided with research, corporate access and other services. The outsourced desk may also have relationships with other sell-side firms for execution, meaning the client is transacting with the provider. Ultimately, the outsourced service provider is the executing broker and stands between the client and other sell-side firms.

Strengths

  • Lower explicit execution costs. 
  • Outsourced trading commissions are bundled as revenue for prime services

Weaknesses

  • Limited execution capability and expertise across asset classes and geographies. 
  • Limited integration with investment teams’ idea generation and portfolio management process. 
  • Entire desk may see orders, not just assigned trader and backup. 
  • Model may create incentive misalignments based on parent organization priorities. 
  • Outsourced desk may be in close proximity to institutional sales trading desks. 
  • Intermediates a fund’s relationship with its brokers and resource partners. 
  • Traditional broker dealers often treat this model as competition. 
  • Non-directed order flow may be mishandled, e.g., internalized or routed to payment for order flow (PFOF) parties.

WHAT’S DRIVING THE GROWTH?

Asset managers are facing compounding pressures, including ever-increasing costs associated with operating a fund. To find ways to stay profitable and drive efficient growth, managers have significantly reduced the size of their trading desks in the last 20 years, replacing traders with software. Even so, desks and their systems are still expensive. At the same time, increasingly complex and fragmented markets alongside regulatory and compliance challenges are driving the need for more software and expert traders. These issues only make creating alpha harder, especially for small funds. With many asset managers struggling to justify a million-dollar desk, outsourcing has become a compelling strategy, delivering superior trading services in a cost effective way. In addition to lowering costs overall, outsourced trading creates the opportunity for asset managers to turn a fixed cost into a variable cost.

2. Traditional Agency Model

Strengths

  • Hub and spoke model provides clients easy access to a wide broker network.
  • Client does not need to be onboarded directly with other broker dealers.
  • Outsourced desk may be able to provide written research reports from its broker relationships

Weaknesses

  • Limited execution capability and expertise across asset classes and geographies.
  • Trading desk may be serving a large number of clients.
  • Limited integration with investment teams’ idea generation and portfolio management process.
  • Intermediates a fund’s relationship with its valued brokers and resource partners.
  • Client’s traditional broker dealers often treat these providers as quasi-competition.
  • Non-directed order flow may be mishandled, e.g., internalized or routed to PFOF parties.

3. Pure Buy-Side Model

Providers act solely as the authorized traders for asset management clients. This structure allows the outsourced desk to be a truly independent, conflict-free extension of the client’s investment team, thereby operating in a pure buy-side capacity. In contrast to the models above, the provider does not have a clearing arrangement, conduct traditional brokerage activities, nor have any competing lines of business with clients’ broker-dealers. Clients settle all of their trades directly with their sell-side counterparty which ensures all trades are booked into the funds account and all commissions and/or spreads paid to the sell-side are from the fund. Meraki has pioneered the pure buy-side model, a unique offering which is more akin to “cosourcing” than traditional “outsourcing.”

Strengths

  • Ability to trade any asset class including global equities, credit, FX, rates, structured products, commodities, and derivatives. Funds are matched with seasoned traders according to their specialization
  • Client maintains direct relationships with their executing brokers and the fund name remains the focal point for resource providers.
  • Low client to trader ratio ensures a bespoke high touch service. Traders monitor portfolios, understand themes important to the manager, and provide him or her with opportunistic flows and market color.
  • Full access to capital markets teams, stock loan desks, IOIs, and buy-side only liquidity pools.
  • Complete integration with both the investment and middle office teams. Traders accept orders in shares, $, or % of AUM and can facilitate settlement of securities and cash management.

Weaknesses

  • Limited execution capability and expertise across asset classes and geographies.

Key considerations when selecting an outsourced trading firm

Building upon an understanding of the different outsourced trading service models, asset managers should ask themselves:

1. Which firm offers the greatest value for our needs? 

Some funds are looking for high-touch, experienced trading; others are focused on growing their broker network. Another way to approach this is to ask, which model would your desk most closely resemble if cost weren’t a consideration? Start by establishing core values—from here, it’s easier to weigh the advantages and disadvantages of the outsourced trading models

2. What am I giving up by narrowing down the offerings to a single focus?

If the sum of the lost values is greater than the value of the single focus, then you may want to reconsider your focus. If, for example, you choose the prime brokerage model, are you limiting your resources and creating concentration risk? If you chose the agency model, are you limiting the products you can trade, forfeiting credit for your commission dollars, or receiving subpar execution? And if you chose the pure buy-side offering, do you have the ability and willingness to set up prime brokers, ISDAs and execution accounts with your preferred counterparties?

Important issues around privacy and conflicts of interests 

At its core, the concept of outsourced trading works best when the service provider is structured so that conflicts of interest are removed, and trust is nurtured between both parties. Funds should complete thorough due diligence into a firm’s policies and procedures to detect potential conflicts of interest and identify mitigating measures.

The most important due diligence items include:

  • Firm Structure – Is outsourced trading the sole source of revenue for the business or is it part of a larger company? What is the ownership structure? What does FINRA BrokerCheck show about the firm’s registrations, lines of business, and ownership? 
  • Handling of order flow – Can the outsourced desk use my fund’s information or order flow to their firm’s benefit and my detriment? Do the firm’s SEC 606 reports reveal that a majority of non-directed orders are routed to Payment for Order Flow (PFOF) parties? 
  • Information leakage – How many people have access to my trading information? How many of my peers does my coverage speak with? What is the client to trader ratio? To what extent is the institutional desk separated from the outsourced trading desk?

About Meraki Global Advisors

Meraki Global Advisors was founded with a rebellious determination to deliver truly conflict-free services to asset managers. Headquartered in Park City, Utah with offices in New York and Hong Kong, Meraki provides outsourced global multi-asset trading, leverage management, and capital introduction services to the asset management industry. Meraki Global Advisors LLC is a FINRA member and SEC Registered. Meraki Global Advisors (HK) Ltd is licensed and regulated by the Securities & Futures Commission of Hong Kong.

For more information, visit the Meraki Global Advisors website and LinkedIn page
Contact:
Mary McAvey
VP of Business Development
(646) 666-7041

Launching A Hedge Fund: How Emerging Managers Can Thrive In Their Capital Raising Efforts

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Meraki Thought Piece

Alternative funds have faced a unique set of challenges since the onset of the Covid-19 pandemic, but few have been more prevalent than capital raising – especially for emerging managers. In this thought piece, we explore the fundamental changes and ways managers can thrive in their capital raising efforts over the next 12 months.

Pandemic pushes allocators to stick with what they know

In 2020, the hedge fund community posted one of its best years for absolute and relative returns. This strong performance in combination with a drastic reduction of in-person meetings has led many capital allocators to adopt a “safe harbor” approach, maintaining steady or increased allocations to existing managers. The hesitancy to consider new funds for their portfolio – particularly emerging managers or unproven investment strategies – is driven in part by the heavy weight placed on traditional face-to-face meetings with prospective managers. The lack of conferences and limitations on travel, which strongly curtail opportunities for in-person due diligence meetings, have also made it problematic for emerging managers to simply access investors. 

As a result, many allocators now have overweight exposure to existing managers and large platforms – imbalances which can potentially impact their diversification profiles and hinder the number of distinct alpha streams within their alternatives portfolios. 

From the fund perspective, some established managers and platforms are benefiting from the disrupted capital-raising process. On the other hand, funds with a launch on the horizon are being challenged by longer raise cycles. Raising capital has always been an uphill climb and, unfortunately, doing so during a pandemic is the same climb at a higher altitude.

Here to stay: New digital platforms and communication mediums

The market has adopted new technologies and communication tools which will continue to be part of the capital introduction process as we emerge from the pandemic. As industry participants look to maintain efficiency gains and manage the uneven path toward a resumption of office work, expect these pandemic-inspired developments to endure:

  • Digital Platforms – Several prime brokers and third-party marketing firms have set up digital platforms to connect funds and allocators, creating “digital clearinghouses.”
  • Video Communications – Virtual meetings are the norm, particularly for international funds and US-based allocators who cannot travel due to lengthy quarantine requirements. Virtual meeting fatigue is as real as in-person meeting fatigue, one must tread carefully.

Five ways managers can thrive in their capital raising efforts

To successfully navigate the transformed capital-raising process, managers would be well served by a renewed focus on the following five areas:

  • Scale or fail – Delaying launch shows a lack of confidence, launch with the capital you have, start building a track record, and then speak with allocators. First year costs for a typical long/short fund are $1MM, primarily earmarked for salaries to assemble a core team that balances investment, operational, and marketing expertise. The remainder used for outsourced partners and technology. Be ruthless in deciding what is needed, as opposed to desired, to build a great foundation through strategic planning, budgeting, capital raising, and legal considerations. 
  • High-quality deck and pitch – Allocators are inundated with marketing decks. Help them cut through the noise with a succinct deck that clearly articulates the strategy through carefully considered design and written content. The pitch should be honed to suit the strategy and target allocator. To generate the greatest impact, dedicate more of the pitch to the story and less to the deck review. 
  • Strategic networking – By working early and often to build strong relationships with the right allocators, managers can draw on a foundation of trust at appropriate times during the fundraising cycle. 
  • Thoughtful social media efforts – Managers can make the most of the current communications landscape by using social media to connect with allocators via LinkedIn, Twitter, and other platforms. The positive effect of staying in front of key contacts when in-person meetings aren’t an option is further boosted by sharing, commenting on, or otherwise engaging with the connection’s relevant content. 
  • Leveraging valuable advisors – By tapping into a select group of experts and advisors, such as third-party marketing firms, prime brokers, CIOs at friendly funds, and former buyside executives-funds can learn how to best position their offering under the current landscape.

How Meraki Global Advisors can help in your capital raising efforts

As a value-added service to our outsourced trading clients, we help managers create a strategic marketing strategy and increase their firm’s awareness among a unique set of investors and allocators. Our experienced team provides start-up advisory services, identifies actionable ways to improve decks and pitches, and creates prospective allocator lists for select introductions. Our services are suited for a diverse range of clients, extending from traditional long-short emerging managers in the very early stages to managers running a multi-strategy platform and existing multi-billion-dollar funds trading globally across asset classes. 

As the premier global multi-asset outsourced trading firm, we take pride in putting our clients’ interests first. Built on a foundation of confidentiality, our unique conflict-free model empowers funds to garner optimal access to liquidity. 

About Meraki Global Advisors

Meraki Global Advisors was founded with a rebellious determination to deliver truly conflict-free services to asset managers. Headquartered in Park City, Utah with offices in New York and Hong Kong, Meraki provides outsourced global multi-asset trading, leverage management, and capital introduction services to the asset management industry. Meraki Global Advisors LLC is a FINRA member and SEC Registered. Meraki Global Advisors (HK) Ltd is licensed and regulated by the Securities & Futures Commission of Hong Kong.

For more information, visit the Meraki Global Advisors website and LinkedIn page
Contact:
Mary McAvey
VP of Business Development
(646) 666-7041

Outsourced Trading Is Gaining Ground in Fixed Income Markets

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Meraki Thought Piece

Outsourced trading first developed in the equity markets as a solution for small and emerging managers. Today, managers of all sizes regularly capture the benefits of outsourced equity trading— and momentum is now spreading to fixed income markets, driven by changes in investor mindset and evolutions in market structure. 

As a premier outsourced trading firm and one of the first to offer a flexible partnership model for fixed income trading, we have a unique perspective into how these developments are unfolding on the ground. Here we discuss six catalysts for the rapid adoption of outsourced fixed income trading and explore how these factors are supporting a strong runway for future growth. 

1. Shifting mindsets around remote work – After spending 18+ months working remotely due to COVID-19, investment teams have demonstrated that portfolio managers, traders, and research analysts are just as effective managing assets while working remotely as they are working together in the same office. They’ve successfully collaborated and navigated volatile markets— all from home. 

As investment teams have become confident working in this new organizational structure, the temporary alternative has given way to a more permanent solution. Managers now recognize they can achieve tight-knit team integration without physical proximity—an important realization that transforms outsourced trading into a viable option.

2. A growing need for geographic diversification – From a business continuity perspective, CIOs and COOs are increasingly recognizing the value of diversifying the geographic locations of their trading desks. COVID-19 has played an important role in this development, having laid bare the health risks of the traditional open trading floor. In addition, the Texas power crisis in February 2021 pushed firm leaders to accept that geographic diversification means more than having satellite offices around a major city. In reality, it should mean having functional offices across the country, or even beyond. Managers are identifying outsourced trading as a key part of the solution, thanks to its ability to provide a simple and inexpensive means to gain geographic diversification and mitigate business risks. 

3. A higher bar for fixed income traders – Today, the role of a pure execution fixed income trader is largely obsolete. Traders must add value to a manager ’s investment process, driven by an ability to provide critical market intelligence in a global multi-asset environment where information flows quickly. The continued electronification of fixed income markets is an important reason why the bar for traders has been pushed higher. As the fixed income world moves way from its historical roots as a predominantly OTC market, traders are required to be proficient users of flexible trading protocols and electronic trading tools. Electronification also allows fixed page 1 income managers to automate certain workflows. As a result, the trader ’s implementation of the manager ’s investment decision plays a more critical role than ever before in fund performance enhancement and consistency as well as genuine alpha generation. 

In this context, asset managers and their clients are capturing significant benefits by leveraging an outsourced trading partner and optimizing trading workflows. Meraki Global Advisors’ outsourced trading solution offers investment managers access to traders who are committed to delivering the high degree of intensity and focus that today ’s market demands as well as proven expertise in the latest fixed income trading platforms.

4. Rising operating costs – In recent years, growth in operating costs has been a driving force behind industry consolidation. When these ballooning costs are combined with fee compression, firms looking to remain independent must identify ways to optimize efficiencies and reduce unnecessary expenses. Outsourcing many operational functions, including trading, is one way to generate these sought-after efficiencies. Outsourced trading turns what is a typically a fixed cost into a variable one: Managers don’t pay for periods of inactivity during which no trading takes place. 

5. Increasing awareness around the benefits of specialization – In a highly competitive marketplace, small- to medium-size firms are seeking ways to secure the benefits of specialization that are typically only available to larger competitors with sufficient scale. In most cases, firms must reach a critical size before individual contributors can stop wearing multiple hats and people can be hired for specialized roles. Outsourced trading empowers portfolio managers and research analysts to stop executing trades and focus solely on their core competencies. Small teams can thereby achieve a depth of knowledge and skill on par with the specialization previously reserved only for larger firms.

6. Greater difficulty accessing liquidity – In our view, this is the most critical factor driving the growth of outsourced fixed income trading. Over the last five years, large broker-dealers and investment banks have fixated on technology implementations, expense cuts, and revenue growth—all made possible by focusing primarily on their largest institutional investor clients. Often, the small- and medium-size investment firms are allotted junior sales coverage and receive limited access to market information and trading desk axes compared to their larger peers. 

In this environment, outsourced fixed income trading offers an attractive solution, allowing small- and medium-size firms to benefit from the expertise and relationships of their dedicated senior trader at the outsourced trading firm. At Meraki Global Advisors, for example, our traders have more than 15 years of buy- and sell-side experience and have cultivated strong relationships with the dealer community.

In sum, a powerful combination of forces is paving the way for widespread adoption of outsourced trading in fixed income markets. Given all its advantages, we fully expect to see outsourced trading become a larger part of the asset management ecosystem in the years to come. 

Meraki Global Advisors is a leading outsourced trading firm that delivers global multi-asset trading, leverage management, and capital introduction services to a sophisticated and diversified client base that includes hedge funds, traditional asset managers, family offices, corporates, and private equity firms. Independent and unconflicted, we help our partners manage complex strategies across the globe and in every asset class by fully integrating into their investment processes. Recognized as the buyside desk of our clients’ investment teams, we trade a range of fixed income asset classes for our clients, including but not limited to HY, distressed, bank loans, IG, EM, CDS, CP, rates, swaptions, and ETFs with their valued street counterparties.

About Meraki Global Advisors

Meraki Global Advisors was founded with a rebellious determination to deliver truly conflict-free services to asset managers. Headquartered in Park City, Utah with offices in New York and Hong Kong, Meraki provides outsourced global multi-asset trading, leverage management, and capital introduction services to the asset management industry. Meraki Global Advisors LLC is a FINRA member and SEC Registered. Meraki Global Advisors (HK) Ltd is licensed and regulated by the Securities & Futures Commission of Hong Kong.

For more information visit the Meraki Global Advisors website and LinkedIn page
Contact:
Mary McAvey
VP of Business Development