"To Outsource Trading or Not to Outsource Trading for Emerging Managers"

Aquamarine Value's conversation with Jeff LeVenn, Managing Director and Head of Outsourced Trading at JonesTrading- April 2018

AV: Can you tell me how you entered the outsourced trading space at JonesTrading?

JL: I joined Jones in August of 2014. As I left my previous firm to join Jones, I noticed a growing interest in outsourced trading in our industry. When I got to understand Jones and the legacy business better, it became obvious that an outsourced trading platform would be a great fit and compliment the trading that was being done by the firm already. I also found that in my travels I spoke with many emerging managers that were currently outsourcing with a competitor and had frustrations with their current providers. What became obvious to me was there was room for another platform and there was a strong interest in something better than what was currently offered by our competitors. I started making a list of items we could do not only differently but better than my competitors. I wanted to build a platform that put the needs of the emerging manager and their investors first. We spent a lot of time listening to the challenges of not only the launching and emerging managers, but their investors as well. We looked at ways where we could improve execution, source liquidity, consolidate the research budget, and get our managers access to as much of the sell side resources as they could possibly get.

AV: What is the primary reason why small emerging managers will outsource their trading? Is it regulation, rising costs, or keeping pace with technological changes?

JL: Fee compression has driven the initial demand for outsourced trading. Launching managers have much smaller management fees to work with to run their businesses. It’s not just small emerging managers, we have been approached by funds managing well over U$500mm in AUM wanting to discuss our offering. Outsourcing is not just about managing costs, although hiring a trader and paying for an expensive order management system creates additional expenses for an emerging manager. We spend many hours working with our managers to help them build research budgets. We provide that manager a team of global coverage so that at all hours of the day he or she has access to an experienced trader. I think the emerging manager has realized that they’d have to hire 2 or 3 traders to replicate the experienced and comprehensive coverage from an outsourced trading desk.

AV: And if emerging managers do outsource their trading, what type of strategy usually outsources?

JL: We’ve seen many different equity strategies outsource their trading. It’s mostly your traditional long only, or equity long /short manager that engages an outsourced trading platform. We trade on behalf of both generalists and sector focused funds.

AV: Outsourced trading also makes sense if a fund wants to enter a new geography and / or a new asset class. Outsourced trading is a relatively low cost for the funds to enter new markets or an asset class.

AV: Has the MiFID II directive increased outsourced trading for JonesTrading thus far in 2018?

JL: We have had a number of inquiries from European clients about our platform, but MiFID II hasn’t been the cause for our new client base in the US. The 1st quarter of every year tends to be an active quarter for new launches. Many of these new launches will outsource their trading and we’ve been fortunate to win a number of new opportunities this year. We do think as MiFID II continues to unfold in the US, clients will focus more on execution, driving even more interest in outsourced trading.

AV: I agree, as MiFID II adoption increases, we will see more firms targeted on the unbundling of research and execution costs benefiting outsourced trading as we have seen a growth in Outsourced Third- Party Research firms based in the US, India, and Singapore.

AV: Can you dispel some of the common reasons or beliefs why emerging manager firms do not outsource trading?

JL: I think there are a number of reasons managers choose to not outsource their trading. I think the first concern is that some managers don’t rank execution quality as a high concern for their new business. Many of these managers trade small and mid-cap stocks where spreads are wider, and liquidity is thin. Execution performance could vary dramatically, and poor execution could lead to hundreds of basis points of unnecessary performance slippage. I also recognize that outsourcing requires building a level of trust with the coverage team. Allowing an outsourced trading firm to understand the names you are trading, the timing, the style of trading is a sensitive relationship. Some managers never get to a point where they feel comfortable sharing this much information with another firm. The reality is every broker dealer handles sensitive client information and sensitive client orders every day. Outsourced trading is no different than the normal trading that broker dealers handle currently. There is strict compliance and surveillance in place to make sure we are handling our client’s orders properly and protecting their anonymity.

AV: The current break even cost for emerging funds that manage < U$500 million is U$86 million¹. In addition, investor reporting is the second area to outsource after middle office processing over the next few years². Firms will continue to monitor their break even as operating and regulatory costs increase in order to remain competitive especially in their early years of survival which will increase the overall demand for outsourcing.

Thank you, Jeff for taking the time to answer these questions.

1. Jack Inglis, Sean Capstick, AIMA/GPP Emerging Manager Survey 2017, 5

2. FIS, Growth 2020: The Changing Chemistry Between Hedge Funds and Investors, 20