The right stuff – How to find the right (outsourced) trading partner
If the current volatile markets have done nothing else, they've convinced many institutional investors just how vital it is to get trading right.
During my years in the industry, I've seen many institutional investors seeking greater control over investment decisions, with many deciding to internalize portions of their portfolios. But they often find the cost of establishing a global trading capability to be much larger than expected. And even if the cost is within reach, the unforeseen risk can be another barrier. Executing trades with limited or no ability to access local trading venues can create levels of risk that are inconsistent with an institutional investor's goals.
At the same time, too many trading firms make the news too often for conflicts of interest, trading abuses and regulatory penalties. How can institutional investors avoid the costs and risks of internalizing trading and still find a partner they trust? We believe there are six key factors to consider.
Six things to look for in your outsourced trading partner
- A pure agency approach – We believe a pure agency approach—with the trading agent working solely on behalf of clients—creates a clear alignment of interest. In contrast, some providers trade proprietarily (such as a large dealer or bank) or as a principal. They may execute the trade the client wants, but they themselves may also benefit, which can skew both their motivation and the outcome. The very structure of an agency model inherently limits conflicts of interest. Does this really matter? Google "FX trading abuse" and see for yourself.
- Experience - Imagine that an outsourced trading provider has visited your offices and has made their pitch to become your trading partner. In their slide deck, they tout the fact that, on average, their traders each have 10 years of experience. Impressive, right? No. Terrifying. In 2020, if a trading professional has been working at their job for 10 years or less, they would have only traded in a low volatility, bull-market environment. They never would have experienced a full market cycle. Right now, in the midst of such astonishing volatility, is that the kind of experience you want to settle for? Believe me—humans, markets and trading work much differently in times of stress. That's just one reason why it's vital to find traders with decades of experience, not years.
- Dual registration – Very few firms have a dual registration as both investment manager and broker dealer, but we believe finding just such a firm is worth the effort. Firms with dual registration have more extensive trading networks of both buy-side and sell-side trading venues. A buy-side and sell-side firm (dually registered) can go to sell-side markets as any broker would, but at the same time can also go to buy-side-only trading markets. This increases their options for the best opportunities for better execution outcomes and helps address liquidity challenges. We believe that no single exchange, no single counterparty and no single venue always has the best price. Therefore, your trading partner should be able to access the greatest breadth of high-quality liquidity and venues on your behalf, in order to increase the likelihood of achieving what you need.
- The holistic approach that asset management provides – It's tempting to get caught up in the stresses of short-term volatility, but your individual trades should always be done within the context of your larger strategy. The trading partners best positioned to provide this holistic understanding also have experience working as asset managers themselves. Traders who have experience within an asset management framework not only achieve the bottom-up perspective of a well-executed individual trade, but they are also structurally required to have a top-down view, keeping the total portfolio in mind. Without this asset management perspective, a client might get a great trade within a single security, but that trade could unintentionally skew their sector exposure. In other words, a single trade may be great, but it could actually negatively impact the portfolio performance. Experience counts here, too, and humans only learn this by trading on behalf of large, long-term funds and portfolios.
- Specialization – If a holistic view is important, then why does asset class specialization matter? Because markets are incredibly complex. They are nuanced by asset class, region and asset type. We believe the best trading partners allow their traders to deeply understand their areas of expertise. And the longer they specialize, the deeper that understanding becomes.
- Size matters – When it comes to trading, size often means access, simply because bigger traders have more potential buying and selling power. I've seen this personally in my time at Russell Investments. In 2019, we traded US$2.24 trillion. That's an average of almost US$9 billion for every day of trading. Over the decades, as our trading size has increased, I've seen our buying power increase as well.
Three trading caution signs for 2020
With today's unmatched volatility and flocks of black swans flying overhead, we traders are keeping a close eye on markets this coming year. There are clearly some issues we're seeing with specific asset classes. Here's what else is drawing our attention:
- Counterparty credit ratings – Counterparty risk is the probability that one party involved in a transaction—such as a bank or some other entity we trade with—might default on their contractual obligation. A counterparty credit rating can help determine the level of risk. We always watch the trends of these credit ratings, but right now, during our pandemic-driven market environment, we are keeping a particularly close eye and adding this additional risk factor into our calculations.
- Trading bottlenecks – As investors search for non-traditional return sources, such as private debt, we believe this has created risks that most investors neither consider nor understand. These once-fringe areas of the market are significantly more crowded than normal. If too many investors need to get out of one of these areas at the same time, the impact of these investments is an increased liquidity demand on more liquid assets, which may be disastrous.
- ETFs – Many ETF investors have been in these products during a bull market. They've never had to sell them in a meaningful way. But we've all recently been reminded—the hard way—that markets are cyclical. So much of the market has been invested in similar-looking ETFs, that the ability to sell them is an ongoing watchpoint.
The bottom line
Trading well in global markets is hard, even in a bull market. Doing so with the highest levels of execution quality and risk management is harder still. Add extreme volatility and liquidity challenges to the mix, and you're left with a don't-try-this-at-home scenario. This is why we believe institutional investors need a trading partner to help. Not just anyone, but one with the right experience, with the right structure and, always, with your best interests front and center.