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Blurring the lines

Most hedge fund firms view outsourcing in terms of both advantages and limitations. But as more managers outsource more functions, the idea of red lines is becoming increasingly blurred.

This article first appeared in the May 2023 Outsourcing Insights Report

Most hedge fund firms view outsourcing in terms of both advantages and limitations. But as more managers outsource more functions, the idea of red lines is becoming increasingly blurred.   

For all the advances in outsourcing adoption in recent years, resistance remains.

Among hedge fund firms surveyed by Hedgeweek, around two thirds said they either had no plans to outsource more or planned to outsource less.

Here, there was a notable divide along geographical lines, with about three-quarters of US respondents resisting more outsourcing, compared to half in Asia-Pacific.

This may be partly a function of size, with Asia-Pacific typically home to smaller firms, but our survey also suggests that sub-$250 million hedge fund firms are similarly resistant to further outsourcing, as are firms with AUM of $1 billion or more. Among our survey sample, mid-sized firms were less likely to be resistant.

So, why are some hedge fund managers not outsourcing more? More than 75% of ‘resistant’ firms surveyed were not considering it “because our remaining functions are best managed in house”.

However, the door is not closed. Nearly one quarter (24%) of this group say they “may do more in the future when technology at outsourced providers has improved in a way that suits our business.” As noted in the previous section, that day may be sooner than many managers think.

Retaining oversight

A recurring mantra when considering the use of a third-party to fulfil a key business function is that you are outsourcing the work, but never the responsibility.

“The key is to ensure the right partner is chosen and that firms have sufficient oversight of their outsourced providers – the process may be outsourced but the responsibility for it cannot be,” says Ken Hope, COO at Aspect Capital.

“Trust and transparency with these providers is extremely important, and if these things can’t be established then that could act as a blocker to a firm’s plans to implement an outsourcing model.”

Chief operating officers are in broad agreement that outsourcing becomes a problem if firms come to rely too much on third parties.
“It is imperative that firms do not create undue reliance on any individual third-party provider (and the fear of this risk can often deter firms from adopting this model) – in reality, this can easily be addressed with suitable back-ups and contingency protocols,” says Hope.

“Historically firms may also have hesitated over investor perception, however – depending on the nature of the service being outsourced – we believe there has been an overall softening of client attitudes towards outsourcing in recent years.”

The investor angle is fundamental – clients must be comfortable with arrangements if they are to last.

Andrew Wall, COO at Greenvale Capital, sees outsourcing as “a balance of skillset, headcount and being able to look your investors in the eye and say you understand and are comfortable with the risks involved.”

That latter point is all-important.

“If you can perform a function internally, that’s good – the next key question is, does that person have capacity?”

The personnel angle is fundamental, especially in an era of ballooning staffing costs. As Dominic Rieb-Smith, managing director and EMEA head of prime and alternative sales at JP Morgan, said at a recent industry event, the WFH trend has been replaced by WFT – the war for talent.

There are some functions hedge fund managers say they would never outsource, led by Trade allocation (67%), Risk monitoring (63%) and Trade limits/restrictions (63%).

More than half (58%) also say they would never outsource Risk attribution, half say Trade communication/routing, and more than two-fifths say Cash payments and margin (47%) and Collateral (43%).

“We believe it is essential that trade processing and shadow navs are in-house,” says Wall.

Outsourcing trade execution – and front office functions more generally – has long been a red line for many hedge fund firms, and more than half of our survey sample (53%) displayed similar sentiment.

One Dubai-based hedge fund professional in between roles interviewed by Hedgeweek said that, at his previous firm, “there was no need to outsource” because of internal expertise across different asset classes and strategies – a selling point for investors.

“Another reason is that the trades are the firm’s secrets,” he added, echoing the concerns of several interviewees. “If you outsource the trading, you never know who can see your trades.”

Front office flexibility 

Despite ongoing unease among managers, outsourcing is increasingly used by some trading desks. “Where Did All the Traders Go? Investment Funds Lean on Outsourcing to Cut Costs” read a headline in February, showing how the trend is moving into the front office.

Here, smaller and newer funds are likely to display more flexibility.

QQM Fund Management, a smaller systematic equity market neutral manager based in Sweden, currently outsources around half of its trade execution function. “We are happy with the results and will probably increase outsourcing more in the future,” says Jonas Sandefelt, Partner, CIO, and Portfolio Manager.

At another smaller hedge fund firm interviewed by Hedgeweek, the execution is done by prime brokerage algorithms. Like QQM, the team is also happy with its approach to outsourcing this function.

“For the smallest new funds, say with less than $100 million under management, the economics can be difficult and outsourced trading, and in some other areas, can be valid,” says Wall.

“Be clear that you have a plan to communicate to investors and prospects – that you outsource these things now but plan to insource them when you reach a certain size threshold. Outsourcing can be a powerful option for such firms.”

What future areas of the business could see more use of outsourcing?

“My sense is that more and more businesses will move to utilising so called ‘managed space’ rather than the traditional leasing model, effectively outsourcing the majority of the office management and reception functions as well as removing the need for expensive leasehold improvement costs on entry and exit,” says Aspect’s Hope.

“The ‘WeWork’ model that was originally developed for small/start-up organisations has already been adapted to suit larger, more established firms providing professional office space at scale including significant flexibility for either material growth or even downsizing if needed – all at a lower all-in cost over the long term.

“Although this is not a model we are adopting ourselves at present it will definitely be a trend we will be monitoring closely and may move towards in the future.”

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