Understanding the Models, Their Benefits, and Considerations

Hedge funds and investment managers continuously seek ways to optimize their trading operations. One of the most compelling strategies to scale trading infrastructure while reducing fixed costs is to outsource it. Outsourced Trading (OT) has evolved and matured significantly in recent years. This comprehensive guide defines OT, identifies its primary beneficiaries, and analyzes the three most common models of OT, comparing pros and cons of each.

What is Outsourced Trading?

Outsourced Trading refers to delegating some or all of a hedge fund or asset manager’s trading activities to an external, specialized trading firm. Rather than managing trades internally, funds partner with OT providers to leverage their expertise, technological infrastructure, and extensive networks to improve execution quality, reduce fixed costs, and access global markets.

Initially viewed as an option primarily for smaller or emerging hedge funds, OT is increasingly adopted by larger investment managers with fund assets well in excess of $1 billion. Larger funds, like their smaller counterparts, have recognized OT’s strategic value in allowing them to focus on core alpha generating functions and helping them scale their trading infrastructure with less overhead.

Target Audience for Outsourced Trading

OT is particularly suited for:

1. Fundamental Hedge Fund Managers and Discretionary Portfolio Managers (PMs): They benefit from specialized trading expertise without diluting their focus on core investment strategy and alpha generation.
2. Multi-Manager Platforms and Pods: They gain scalable instantaneous trading infrastructure and flexibility across strategies and asset classes, eliminating redundant internal costs while maintaining autonomy and reducing operational complexity.
3. Credit and other non-equity managers: They leverage dedicated trading expertise in less-liquid, complex instruments such as distressed debt, structured credit, or OTC derivatives.
4. PMs running Global Strategies: They secure seamless 24-hour trading coverage across global time zones and asset classes, enabling quicker responses to market movements, better access to regional liquidity, and increased operational efficiency without the overhead of multiple regional trading desks and back-up traders.

Three Models of Outsourced Trading

1. Classic Outsourced Trading: Bundled solutions

In this traditional model, an asset manager outsources its trading desk to an external provider who offers other services like institutional brokerage.

Pros:

• Cost Efficiency: Converts fixed overhead costs (salaries, technology, compliance) into variable costs, paying only for executed trades.
• Scalability: Quickly scale up trading activities without hiring additional traders or infrastructure.
• Global Coverage: Access to many global markets around-the-clock without maintaining in-house teams across multiple time zones.

Cons:

• Potential Loss of Control: Limited direct oversight of trade execution.
• Conflicts of Interest: Providers may prioritize financially beneficial venues and existing execution brokerage relationships, potentially compromising best execution
• Reduced Customization: Less personalized trading strategy integration and general fund nuances compared to in-house teams.

2. Co-sourcing (Hybrid Outsourced Trading)

Co-sourcing combines internal trading teams with external outsourced support, focusing on specific asset classes, geographical markets, or overflow periods

Pros:

• Enhanced Expertise: Access specialized knowledge for specific markets or instruments without restructuring internal teams.
• Operational Flexibility: Maintain control over certain strategic trading operations internally while outsourcing more standardized or complex trades.
• Broker Network Expansion: Gain access to broader liquidity networks and global broker relationships.

Cons:

• Complexity in Coordination: Requires seamless integration between internal and external teams, potentially leading to operational complexity.
• Risk of Misalignment: Challenges in ensuring consistent communication and strategic alignment between outsourced and internal resources.
• Low-touch models: Traders may not be fully familiar with the investment manager’s style and trading strategy leading to poor communication and lost opportunities.

3. Integrated Trade Management (ITM)

Pioneered by firms like Meraki Global Advisors, ITM provides a high-touch, deeply integrated service acting as a direct extension of the fund’s internal investment team.

Pros:

• Optimal Control and Transparency: PMs maintain full visibility and control over trade execution and strategy implementation.
• Personalized Service: Dedicated  traders with low client-to-trader ratios ensure high-quality, tailored trading execution.
• Conflict-Free Execution: Uses client-defined broker lists, ensuring alignment with the client’s interests and optimal execution.

Cons:

• Potentially Higher Cost: More personalized service could be marginally more expensive than traditional OT.
• Resource Intensive Integration: Initial setup requires detailed coordination and communication channels to align internal and external teams fully.

Choosing the Right OT Model

Determining the best model of outsourced trading depends on several factors, including:

• The size of your team, fund AUM, and volume of trades.
• Complexity and diversity of your investment strategies.
• Importance of maintaining direct control, oversight, and street relationships
• Specific market expertise required, particularly for emerging markets or complex instruments.

ITM is the future of Outsourced Trading

Outsourced trading, particularly Integrated Trade Management, has become essential for sophisticated hedge funds and asset managers seeking to enhance operational efficiency, expand global reach, and optimize trading performance without sacrificing control. While the classic OT model is still viable for funds looking to control some costs, co-sourcing offers further flexibility. However, ITM remains the optimal solution for those seeking a highly personalized, conflict-free, integrated trading desk experience.

By carefully considering the unique requirements of your fund, you can select the outsourced trading model that most effectively enhances your trading operations, ultimately driving superior investment outcomes and greater strategic agility.