Over the past three decades, the growth of the asset management industry has been accompanied by a broad-based evolution in a critical element of the investment process: trading.
While historically viewed by the asset management industry as a high cost, operational necessity, the implementation leg of the investment value chain – known as the buy side trading desk – plays a critical but often overlooked role in fund performance enhancement and consistency, as well as genuine alpha generation.
Despite benefiting from numerous technological developments over the years, especially the growing use of electronic trading, the buy side trading desk has had to contend with several challenges, including a dearth of competitive pressure, unresolved inefficiencies, and growing cost burdens. In more recent years, asset managers have witnessed a significant reduction in fees on the back of industry consolidation, the entry of new digital-first players, and a secular trend in favour of low- cost, passive investing. In response, many asset managers have resorted to cost cutting and/or a lack of investment to protect their bottom lines.
The size of the industry is still significant, however: for example, in 2020 alone, asset managers spent USD 14.9 billion globally, or 51% of their budget, on equity trading expenses such as commissions, capital commitment, and so on.
While cost cutting may appear to be a logical response to rising industry headwinds in the short term, the fact is, many buy side trading desks suffer from significant internal inefficiencies that result in sizeable economic waste. We estimate that some of the largest fund managers are spending up to USD 14 million p.a. in explicit costs for their execution operations, with roughly one-third of this (i.e. USD 5 million p.a.) being squandered as a result of structural, technological, cultural and operational problems.
More critically, however, are the implicit costs being generated by asset managers from maintaining sub-optimal trading operations, many of which are frequently overlooked. We estimate a lack of technological proficiency, poor choice of execution method, and the widespread absence of internal / external partnerships is, on average, impacting fund performance by 1.2-2.7% p.a., costing the very largest asset managers in excess of USD 18 billion p.a. in opportunity cost (i.e. lost fund performance) to their end asset owner clients.
The noise around the outsourced trading industry has grown very loud in the past year, and the sheer number of participants now is very striking. Despite this, we see a limited, genuinely accretive usage argument for a significant proportion of the asset management industry. While staffing a full-time desk is no doubt a meaningful economic commitment, outsourcing, despite its marketing, follows the basic tenet of Best Execution in somewhat of a haphazard manner. In farming out trading, it is likely that an asset manager could be falling short of both its performance and regulatory obligations.
Our extensive research, along with interviews with industry professionals on both buy and sell side, highlights that a persistence in carrying sub-optimal practices is rife within the trading industry, reinforcing the need for structural changes and a more fundamental reinvention of the buy side trading desk.
We identify three key pathways asset managers can explore to make their trading operations more accretive to their investment process, including outsourcing, internal optimisation, and a hybrid solution.
Through a careful examination of various strategic, operational, and financial considerations, we see sizeable benefits for asset managers who can get their trading construct right; from improved client engagement, execution quality, operating efficiency, and teaming / culture, to reduced internal costs.
Given the sheer size of the economic upside at stake for their end clients, we see this as a critical time for the asset management industry to start trading up.