Supplemental trading: Expanding the reach of buy-side traders
The asset management industry is undergoing a period of significant and radical change, largely driven by regulation, advancements in trading technology and the impact of passive.
As if these challenges weren't enough, equity commissions are down 45% since 2009. In no uncertain terms, players on both sides of the fence are being forced to rethink past practices.
For buy-side equity traders, this means carefully managing costs and counterparty relationships, as well as mapping out a plan to acquire research while seeking best execution. For the sell-side, this likely leads to providing less research, and in fewer sectors, focusing on select clients and managing with an eye toward profitability versus market share.
The days of being all things to all people are over.
While these changes will be disruptive, they will also create new opportunities. For example, at our firm, Tourmaline Partners, we are seeing increased demand from investment managers who have their own traders or trading teams, as they seek to supplement their resources. It is clear that this demand derives from the aforementioned changes.
This new construct, supplemental trading, is simply a byproduct of outsourced trading, a practice that had its genesis with emerging managers, typically hedge funds at launch. Our nascent growth with more-traditional investment managers has made clear that, up until now, much of this community was unaware that supplemental trading existed and was an available resource. So here we offer a primer on what an investment manager should know about supplemental trading.
A supplemental trading solution is one that allows a buy-side trader to engage experts for some of their execution, as opposed to outsourcing the entire trading function. This can be used to both address existing challenges and accomplish specific goals. A buy-side trader would use a supplemental trading solution to:
Improve access to liquidity when trading small caps or difficult-to-trade names
o Trade developed, emerging or restricted international markets
o Avoid having a lone overseas trader or night trader.
o Avoid leaving unsupervised orders on a sell-side desk overnight.
o On all trading
o When building or exiting a large position or a sensitive name
Reach specific brokers that don't cover you, in order to
o Pay for research, meetings or calls, in lieu of (or to complement) a commission sharing arrangement
o Access liquidity that you don't see.
Access options trading expertise/implement hedging strategies
Address bandwidth / capacity issues
o On busy days or when traders are on vacation
o Over the long term (to avoid adding staff)
Most investment managers have cut their broker lists to be more efficient and to reduce expenses. While a sensible strategy, it creates challenges when traders need to access specific brokers opportunistically and infrequently.
We also note that rapid growth and advancements in trading technologies have created a fragmented liquidity heat map. This has made it necessary for buy-side traders to devote increasingly precious time and resources on evaluating new algorithms, dark pools and trading venues in order to remain competitive. Leaning on experts can help to ameliorate these challenges.
As demand for supplemental trading grows, more brokers are entering the space and existing players will likely commit additional resources. This growth will lead to a number of different types of offerings and will require a fair amount of due diligence from investment managers who are seeking differentiated trading expertise.
At Tourmaline, our specific focus is on providing investment managers with a buy-side solution that expands a trader's reach to the sell-side, improves execution performance and reduces costs. In doing so, we also provide brokers with a path to order flow and revenue from investment managers with whom they no longer work or prefer not to set up and service directly.
The good news, so far, is that clients are seeing results. In the 2018 report "Outsourced Trading: Helping the Buy Side Improve Execution and Enhance Operational Efficiency," Greenwich Associates found that, among participating institutional investors using outsourced trading desks, 71% were extremely satisfied with the service.
As our industry continues to change, it is becoming clear that supplemental trading resources and expertise can be a vital and often indispensable resource for much of the buy-side community.